Investing in futures contracts

Futures contracts - what are they and how to investing in them?

Futures contracts are an interesting alternative to equity investments. Year after year they are becoming more and more popular not only among big players but also among small investors.

The specific characteristics of the futures contract

A futures contract is a contract to buy or sell a financial instrument at a fixed price on a specified date.

In practice, this means that by buying a futures contract, the investor provides for the possibility to purchase a fixed price at a fixed price in the future, regardless of the market price of this asset in the future.

Example 1:

By buying a contract for 100 stocks of a given company for USD 120 each, the investor guaranteed that on the contract expiry date, he would buy the above number of stocks at this price.

Each contract has certain parameters: the underlying instrument, maturity, the contract size (usually 100 stocks) and price (120 USD).

Futures contracts are traded on the stock exchange and are fully standardised. Contract parameters are predefined by the exchange and the investor can only choose from a range of available contracts the one that best suits his needs.

In practice, most futures contracts are settled financially, without physical delivery of the underlying instrument. Thus, in the above example, the Investor will not be forced to buy 100 stocks on the expiration date - instead, he will only receive the difference between the determined price of a given company and the actual price of that company on the settlement date.

What is investing in futures contracts?

As in the case of stocks, futures contracts can be bought (long position) or sold (short position). However, unlike stocks, the investor can sell a contract even if he has not bought it before and does not have it on the account. The price of the contract changes in a way that reflects the price movements of the underlying instrument, i. e. having a long position the investor earns from the price increase, and having a short position on its decline.

Let's explain it using the example of futures contracts for the WIG20 index.

Example 2:

The investor believes that in the near future the mood on the stock market will be positive - for example, information coming from across the ocean will contribute to the growth of the WIG20 index, which opens a long position in futures trading for this index by buying 5 futures contracts. If the trader's expectations are checked and the index value actually rises, then he or she will make a profit.

This is due to the fact that if the index increases, the price of the contract increases and the investor will sell it at a higher price than the purchase price. However, if the index falls, the investor will suffer a loss. In order to complete the investment, the investor will sell 5 futures contracts, thus closing the previously opened position.

Example 3:

The investor estimates that in the nearest future the market sentiment will be negative and the value of WIG20 index will fall (e. g. due to information about the fragile financial situation of EU countries). It therefore opens a short position in the futures contract for this index, selling 3 contracts.

If it turns out that he was right and the value of the index drops, the investor will make a profit by buying 3 futures contracts at a price lower than the price of its sale (will close a short position at a lower price than the price at which it was opened). Naturally, if the index rises, the futures exchange rate will also increase and the investor will suffer a loss.

Advantages of futures contracts:

Possibility to earn money on inheritances;
Leverage.

Futures contracts: index mapping

Investing in futures contracts is often a simpler and cheaper alternative to investment in an underlying instrument. For example, instead of taking a position in the stocks of 20 companies included in the WIG20 index, the investor may simply open a position in the index contract.

Futures contracts: complex strategies

The position in futures contracts is often only part of a more complex strategy. For example, a holder of a stock can hedge against a decline in its value by opening a short position in stock contracts.

The value of such a portfolio will not change in the event of stock price fluctuations, and since the investor will remain a shareholder of the company, it will retain its voting and dividend rights.