An important point to understand when trading the futures markets is that very few futures contracts are taken to delivery. Buying one contract for, say, June 1997 delivery today and selling one contract for June 1997 delivery tomorrow cancels out the delivery obligation. All that is left is the difference in the buying and the selling prices. While this creates a natural environment for the speculator it also provides an excellent medium for hedgers. However, even the hedger does not have to run the contract to delivery. Since the future and the underlying instrument move closely together, a natural seller of the underlying commodity can hedge by selling the futures contract. So, if a wheat farmer believes that the price of wheat is going to fall by harvest time, he can go short of the wheat futures. He then has a choice of whether to run the futures position to the maturity date and deliver wheat as prescribed by the Exchange or, if the wheat price has fallen, he can buy back his wheat contracts to take a profit in the futures market. This'll offset the fall in the price of the grain in the cash market over the same period of time.

Let us take an example using financial futures. Imagine that three brothers are left a <156>l.5m portfolio of blue chip shares by their great aunt. It will take a little time for the estate to be wound up and the current level of the market is at 3760. The brothers are worried: inflation is picking up and an interest rate rise looks possible. It is January and the world and his dog are bullish. A fall therefore seems more than likely!

The brothers decide to hedge their market exposure. At the moment the FTSE June future is trading at 3779 (representing an underlying portfolio value of <156>25 x 3779 or <156>94,475). In futures terms, the inheritance represents <156>l.5m divided by <156>94.475--or 15.87 contracts. They therefore decide to sell 16 contracts of the June future at 3779.

Suppose they are proved right. The market takes a wobble and by the time probate comes through in June and the portfolio is ready to be divided amongst the lucky trio, the index has fallen back by 12.2 percent to 3300. By now, the FTSE June future has lost all premium and is trading at the same level as the cash index, i.e., 3300. The 16 contracts are re-purchased at 3300, producing a profit on the deal of 479 index points x <156>25 x 16 = <156>191,600. The <156>l.5m portfolio has shed 12.2 percent of its value (Auntie was good at constructing an exact index-tracking fund) which represents a decline of <156>183,000. The status quo has been more than maintained (being slightly over-hedged).

Fair Value, Arbitrage And Spreads

In the example above, it is apparent that there is a difference between the spot market of 3760 and the June futures price of 3779. This difference will narrow as the futures contract approaches its delivery date. On the last trading day, the futures price and the underlying "cash" price will converge. The exact value of the correct futures price can be calculated and is known as the fair value.

This calculation is illustrated most easily by reference to the `Footsie' future. The UK "cash" investor buys shares in the 100 companies in the FTSE index (in the appropriate weightings). His cost of finance is measured either as the cost of borrowing the money to buy the shares or (if already `long' of cash) the opportunity cost of using that money for equities. This cost is offset by the dividends that are received from the shares.

The investor in futures simply places the same amount of money on deposit and buys the FTSE index future. He earns interest on his money but receives no dividends from shares (since he does not own any) or from the future. At the maturity date of the futures contract, both investors will be in the same position vis a vis the capital level of the index. The future and the index will be the same. The futures investor will, however, have received more income from his cash deposit than the investor in shares received from dividends (assuming that interest rates remain higher than equity yields). It follows then that, in order to avoid the provision of a risk-free arbitrage, the futures investor will be required to pay a premium over the underlying index value at the time that he buys his future. Let us suppose that interest rates are 6% per annum and the yield on the FTSE-100 index is 4% per annum. The futures investor has a 2% per annum advantage over the equity investor as his money is earning 6% rather than 4%. So, given a 3-month expiry cycle, the futures trader would expect to pay (or receive) one quarter of this (i.e., 0.5%) as premium over the cash index for a 3-month-to-run future.

The future will not always trade at the fair value but may be "cheap" or "dear" depending on supply and demand in the market. However, any significant divergence from fair value leads to profitable opportunities for arbitrageurs and their activity will tend to limit such divergence. The precise fair value calculation as indicated above is the net balance of 1) the cost of finance and 2) the revenue stream during the relevant period. Not every market participant will estimate the same fair value since costs of finance will vary and views on future dividend flows or interest rate levels may be different. This is what makes a market. If the index future runs to a premium significantly greater than the calculated fair value, arbitrageurs will sell the future and buy the 100 underlying shares, thus locking in a risk-free profit. The traders need to take into account the transaction costs of this process, hence the need for a significant overvaluation of the futures contract.

The calculation of fair values leads to a number of interesting low-risk trading possibilities. Calculating the fair values of two different delivery months on the same underlying instrument means that any serious divergence from the fair value of the `spread' can be exploited by buying one delivery month and selling the other delivery month.

Speculating In Futures

As mentioned above, futures trading provides an excellent medium for the short-term speculator. Dealing costs are minimal (typically for a small deal on the FTSE index future this will be around <156>15.00 to open one side of the transaction and <156>15.00 to close it out). The opening and closing charges are normally aggregated and charged on the opening transaction as a `round trip' commission. The charge covers all brokerage, clearing and exchange fees.

Dealing spreads are normally very close. Indeed, there may not be any at all! There are no registered market-makers as such in the futures trading `pit.' The crowd is made up of brokers (acting for clients) and locals (who are trading their own account for a living). In response to a request for a quote, the crowd will respond vociferously with the levels at which they are willing to bid for, or offer at, the contract at that particular moment. In a large `pit' this normally results in a differential that can be as close as one point. In the case of the FTSE future, this would be worth <156>25.00.

Thus, for a cost of <156>30.00 commission plus <156>25.00 dealing spread, a day-trader in a single futures contract can speculate on the direction of the market for a portfolio valued at L25.00 x the current index level. (At 3750, this would represent <156>93,750--making total dealing costs a minimal 0.06%.) By competing in the crowd, the trader can try to buy at the bid or sell at the offer (or at least to better his price by offering to trade in the middle of the best bids and offers at that moment--thus becoming the best bid or offer himself, until either he trades or the price moves away from him). No stamp duty applies. If one contract is bought in the morning and, by the end of the day. the market is up by 1.51% (56 points), the profit will be 56 x <156>25.60 or <156>1,400.00 (less costs of course). A rise of 1.5% on the <156>93,750 portfolio equates to <156>l,406.25.

Before getting too carried away, it is important to remember that this is a `market' for serious players only. A futures contract carries with it a theoretical unlimited liability. If you have purchased one contract and an unexpected announcement sends the market `gapping down' by 150 points, you could be left nursing a nasty <156>3,750 loss. In practice, of course, it is usually possible to employ `stop' limits--but a really big move can `gap' right through these.

The Mechanics Of Trading

The methodology of trading futures is fairly simple. Before you open a position, your broker will require some initial margin to be in place. This is the amount set by the exchange before opening one contract. For private clients, who will be sending cheques back and forth, many brokers will ask for a sum amounting to 10-20 percent higher than the exchange's minimum. Initial margin can be covered by cash (in which case it will have to be in the same currency as the underlying futures contract) or--with some clearers--by other acceptable securities.

If a position has been held overnight, it is `marked to the market.' Daily variation margin--the amount covering the profit or loss on the position between the traded level and that day's closing (i.e., settlement) price--will be required to be paid to, or will be received from, the clearing house next morning. This variation margin has to be in cash (unlike initial margin, which the clearing member will probably be covering with his bank guarantee). Variation margin cannot be covered by acceptable collateral as the required cash sum must be passed physically to the clearing house and will thus have to be in the correct underlying currency. So, if you are dealing in a deutschemark future, it would be wise to change some currency before you start, or to see if your broker has a facility to operate a deutschemark account. Variation margin means that all open futures contracts are marked-to-market on a daily basis, so you pay for any losses as you go. In this way the clearing house (and individual members of the market) can be sure that there will be no nasty accumulation of debits at the expiration of a contract during the life of which there has been an exceptionally large move.

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Relocated 04-06-97
Last updated on 04-06-97

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