FAQs (Futures & Options) General Questions
What are derivatives?
Derivatives is a term used in the industry to describe financial products such as futures and options which are derived from other existing products. For example, equity futures and options are derived from equities in the underlying share market.
What are futures and options?
Technically, a futures contract is an agreement between buyer and seller to buy or sell a particular asset (eg shares) some time in the future at a price agreed today. Futures contracts may be cash-settled or require physical delivery of the underlying asset. For equity futures, a cash-settled contract requires a cash amount to be paid on the settlement day, reflecting the difference between the initial futures price and the price of the underlying shares when the futures contract reaches maturity. In doing this, the investor can buy and sell contracts without ever owning the shares in the first place. This aspect is often quite attractive to investors because it prevents them from paying stamp duty which they would otherwise have to pay if they were trading shares.
Options give investors the right, but not the obligation to buy or sell a particular asset (eg shares) at a fixed price on or before a specific date. Unlike futures contracts, the potential loss to the buyer of an option is limited to the initial price (or premium) paid for the contract, regardless of the performance of the underlying share. Like futures, options can be used to try to capitalise on an upward or downward movement in the market, but also generate returns in a static market.
How do futures and options work?
Like insurance allows the owner of a car to protect their asset for a premium, futures and options allow investors to protect their investments. For example, suppose a fund manager knows they will have a certain amount of money to invest in shares at a fixed time in the future, but they believe the market is going to rise and there is a risk they will have to pay a lot more for the shares. They can purchase options on the same shares for a relatively small outlay (called a premium), and use the profit from the options to offset the higher price they would have to pay for the shares when the money becomes available.
Futures and options were originally developed in order for investors to protect their investments and manage their risks. Prices can change drastically over time and investors are able to use futures and options markets to protect themselves from uncertainty in price movements. The uses of derivative products have broadened over time, and now investors also use these products for profit by speculating on which way the market will move.
How can futures and options benefit private investors?
Broadly, futures and options allow investors to profit from a rising, falling or static market.
Futures and options are capital efficient investment tools, which can offer private investors greater exposure to the market than traditional investments, for a smaller initial outlay.
In particular, equity derivatives offer private investors the opportunity to enhance their equity portfolio by increasing the range of investment opportunities and tools available. They can help to reduce costs, enhance returns and manage price risk with greater certainty, precision and economy.
Are futures and options confusing?
While futures and options are often perceived as complex or confusing, the reality is that the principle of futures and options is no more difficult than the underlying shares market. If used correctly, futures and options can be powerful investment tools that provide many advantages over trading shares including high liquidity, low transaction costs and leverage.
Are futures and options too risky for private investors?
Derivatives such as futures and options were originally developed in order to help investors manage risks and ensure money wasn't lost in the event of the market going against their position.
One of the unique aspects of futures is the high gearing or leverage that they provide. This means investors have the ability to obtain exposure to a relatively large asset amount for a small initial outlay. The result is a high risk/high reward investment. For example, The London Clearing House requires investors to deposit an initial margin which is refunded when the futures position is closed out. If the market goes the wrong way, it is easy to lose more than the initial margin deposited because the initial margin gives the trader exposure to a portfolio value that is many times greater than the initial margin amount.
Unlike futures contracts, the potential loss to the buyer of an option is limited to the initial price paid for the contract, regardless of the performance of the underlying share. This helps investors to control the amount of risk assumed. However the seller of an option is exposed to a higher degree of risk. Holding underlying shares against which calls are sold, or cash against which puts are sold, ensures that the seller has a 'covered' position.
Like most investments, trading futures and options can be a potentially high risk strategy. Private investors can lessen the risks of trading by ensuring they have a high degree of product knowledge, they always invest within their means and they deal with a broker who is experienced in the futures and options industry.
Which LIFFE products are most suitable for private investors?
LIFFE provides derivative products on a range of international short term interest rates, bonds, swaps, equities and commodity products for institutional and private investors.
Of our product suite, our range of equity futures and options contracts are most suited to private investors. Our Individual Equity Options and FTSE 100 Index Futures and Options are currently the most popular among retail investors because their smaller contract sizes make them more affordable for the retail market. The recent launch of Universal Stock Futures, means there are now even more opportunities for the private investor.
Universal Stock Futures are a range of futures contracts on the shares of individual companies worldwide. They increase the range of investment opportunities offered to private investors by enabling them to trade futures contracts on a selection of the world's top shares, through one access point, for a fraction of the cost.
Is it a bad time to invest in equity markets when they are falling?
Falling markets can be a very lucrative time to invest in the equity market. Many bargains can be found in the share market because investors are effectively buying when prices are low therefore obtaining more value for money.
Futures and options can be used to make a profit when stock markets are falling by taking an opposite position to the market. For example, Universal Stock Futures allow investors to make gains from a fall in the stock market by selling a Universal Stock Futures contract, without owning the stock in the first place, and then buying the contract back at a lower price to realise a profit.
Approximately how much can be made or lost with futures and options?
Because the amount of money that can be made or lost varies between product, three examples have been provided to give an indication of the potential of trading futures and options.
Universal Stock Futures For Universal Stock Futures on UK stocks, the profit/loss is £10 per penny move in the futures price. For example, if an investor buys one HSBC Universal Stock Future at 750p, and the market rises to 770p, they can sell for a 20p gain = £200 (£10x20). If however, they had of sold short initially, the loss would have been £200.
For European Universal Stock Futures, the profit/loss is €1 per €0.01 move in the futures price. For US Universal Stock Futures, the profit/loss is US$1 per US$0.01 move in the futures price.
FTSE 100 Index FutureFor FTSE 100 Index Futures, the profit/loss is £10 per index point move in the futures price.
Equity Options For Equity Options, the premium paid/received is £10 per penny. Unlike futures, if the investor buys an option, the maximum loss is limited to the initial premium paid.
What is a market maker?
Market makers are firms who have signed a formal agreement with LIFFE to provide quotes in certain sizes/spreads. Market maker schemes are designed to provide visible liquidity in the contracts they operate in.
How do corporate events such as takeovers/mergers/dividend payments affect futures and options on equities?
The effect of a corporate event on futures and options contracts depends on the specific nature of each event. In general, LIFFE has a policy that futures and options contracts will be adjusted so that holders or writers are not unduly advantaged or disadvantaged by the event. This may be achieved by changing any or all of the price, lot size or the deliverable asset. Generally futures and options are adjusted for special dividends, but not for ordinary dividends. Also, index futures and options are not adjusted to reflect corporate events, but in some cases, the index calculation may be adjusted.
What is open interest?
Open interest refers to the number of outstanding contracts that remain open. For example, if a position was taken in a contract, and at the expiry of that contract, instead of closing out the position, the trader decided to roll the contract over (ie open a similar position in the next expiry month), their open interest in that contract would continue. If however the trader decided to close out their position, the open interest for that contract would decrease.
How does margining work?
Margining is the risk management system adopted by the London Clearing House who acts as central counterparty for contracts traded at LIFFE. There are two major types of margin - initial and variation.
Initial margin is a deposit required on all positions and is returned by the clearing house when positions are closed. It protects the LCH from any adverse price movements in the event of a clearing member defaulting.
Variation margin reflects the change in value of a portfolio of contracts and is calculated and paid daily.