What is a future?
Quite simply, a future is an agreement (obligation) to buy or sell a given quantity of a particular asset, at a specified future date, at a pre-agreed price. Futures contracts have standard delivery dates, trading units, terms and conditions. Futures can be based on any number of underlying assets. In addition to offering futures and options based on individual shares and stockmarket indices, LIFFE also offers futures and options based on bonds, interest rates and soft and agricultural commodities.
LIFFE's equity futures hold a host of investment opportunities for you as a private investor. Whilst futures on equities allow you to gain exposure to specific shares, FTSE 100 Index Futures allow you to gain exposure to the FTSE 100 Index which tracks the performance of the UK top 100 blue chip companies.
You can "open" a futures position by either buying or selling a future. You can "close" your futures position by doing the opposite - either selling or buying the same future. In practice, most futures contract positions are "closed out" before they expire.
If you hold a view that the underlying asset will rise you could buy futures - known as a LONG futures position - which commits you to take delivery of the underlying shares, or equivalent cash value, at a pre-arranged price and by a certain date.
If your view is that the share prices for the underlying asset will fall, you could sell futures - known as a SHORT futures position - which commits you to deliver the underlying shares, or equivalent cash value, at a prearranged price and by a certain date.
Potential Risks and Rewards
There is no way of knowing for sure the direction of the prices of the underlying asset nor the price of futures in advance. Therefore, like many investments, futures carry a risk that market prices may go in the opposite direction of the view held.
As you have seen, futures can be used in different market conditions. Let's consider equity futures. Remember that equity futures are financial instruments whose price movements are derived from the price movements of an underlying share price or index.
Here are two distinctive benefits of trading equity futures:
You can profit in a falling market as well as a rising market.
Normally, when investing in shares, you would go by the rule of buy low and sell high in order to profit from market prices. In the futures market, you have the opportunity to sell futures, known as going short. So, if a view is held that a share price will fall, consider selling futures. If the view materialises and the price of the future price falls in line with the underlying share price, the position can be closed by buying back the future for less in order to make a gain.
· Cost efficiency
An additional benefit of trading equity futures as opposed to trading shares, is the lower commission structure. Futures trading commissions typically represent a third of the costs for those to trade the underlying market and cash-settled futures contracts. In addition, profits from futures do not incur any stamp duty.
How are futures priced
Futures prices are calculated in a structured way.
When you look at a futures price you will see two prices:
BID PRICE is the price at which a trader is willing to buy a futures contract.
OFFER PRICE is the price at which a trader is willing to sell a futures contract.
The futures price should be equal to the cost of financing the purchase of the underlying asset and the cost of holding (or storing) it until expiry of the futures contract.
LIFFE's range of equity futures are derived from share prices and indices. So, in this case, the total cost of buying shares and holding them until expiry of the future contract is made up to three main elements:
· The price of the underlying shares
· Any interest income foregone by holding shares rather than cash
· Any dividends paid to the holder of the shares before the expiry of the future
Or as a formula:
Fair equity futures price = today's share price + interest costs - dividends received
Futures on equity indices are priced on a cost of carry basis. The fair value of the index futures contract is determined by adjusting the current cash index price by the net cost of carry of the underlying basket of shares replicating the index. Cost of carry reflects the cash flow considerations of a seller of futures over the life of the contract as (s)he holds the underlying basket of shares. The cost of borrowing for the financing of the index basket is the main factor, but the income generated from holding the underlying basket of shares must also be taken into consideration. The cost of carry can therefore be defined as the difference between the cost of financing the holding of the basket of shares comprising the index and the income earned on these stocks in the form of dividends (dividend yield).
Futures and options are products that can transform your trading and investment activity; increasing profit potential and giving you the means to control risk too. LIFFE is committed to bringing this world of trading and investing opportunities to the private investor, both through education and through a continuous process of product enhancement and development. In conjunction with education supplier Trade Basics, LIFFE is pleased to bring you a series of interactive education modules in The Learning Centre.
You can view the prices for LIFFE's range of equity futures and options at www.liffe-data.com. Here you will see 15 minute delayed price data. In addition, free live prices for LIFFE's Universal Stock Futures are also available.
How futures can be used?
Futures contracts can be used in many different ways depending on your investment objectives. Here are two examples:
· To safeguard or "hedge" your existing underlying assets if you believe the price will fall.
You could consider opening a futures position to protect your existing asset (eg. your share portfolio) in the event of a down turn in prices. As a holder of the asset, you can sell futures against your equity portfolio to avoid making a loss and without having to incur the costs associated with selling your assets. To "close" the futures position by buy the equivalent amount of futures in the market. Losses in the underlying asset can therefore be compensated by profit made on the futures position.
· To profit from volatile market conditions
Futures provide the opportunity to profit from the upward and downward turns in the prices of underlying assets. For a view that market prices will rise, consider buying futures (remember this is a LONG futures position). Conversely, for a view that market prices will fall, consider selling futures (remember this is a SHORT futures position). If the view held materialises, the position can be closed by undertaking an equal and opposite position in the same market in order to profit from the price difference. Remember to close a long position you would sell futures and to close a short position you would buy futures.
Futures can transform your trading and investment activity; increasing profit potential and giving you the means to control risk too.
LIFFE is committed to bringing this world of trading and investing opportunities to the private investor, both through education and through a continuous process of product enhancement and development. In conjunction with education supplier Trade Basics, LIFFE is pleased to bring you a series of interactive education modules in The Learning Centre.
Understanding product specs or contracts
What is a product specification or contract?
LIFFE's futures contracts are legally binding agreements that have standard parameters such as size, expiry, exercise and settlement. LIFFE futures therefore have standardised contracts or product specifications. This improves liquidity and the ease of trading between buyers and sellers.