01 futures contract
Spot, forward contracts, and futures contracts, what are they?
The first point of futures trading is futures contracts. Usually, when we buy things, we pay for them and receive them at the same time. This is called spot trading.
In contrast, a forward contract is a deposit paid first and delivery made later. The forward contract market first appeared in the Edo period of Japan. At that time, rice was a very important strategic resource because once preparing for war, the general needed to buy a lot of rice from farmers to prepare for war. However, the general did not know whether the price of rice would rise or fall next year. So the general said to the farmer, “I will pay you now, and you will give me rice next year at this price. Regardless of whether the price of rice rises or falls next year, you must follow this price.” The agreement reached between the general and the farmer is called a forward contract.
The advantage of this contract is that the general can have enough rice, and the farmer does not have to worry about the price of his rice next year. If it rises, it’s good. If it crashes, the hard work of that year will be in vain. Therefore, as long as the price set now is profitable, farmers can farm with peace of mind. This practice of using forward contracts to lock in product prices in advance to arrange future production work is called hedging.
However, there are three problems with forward contracts. Therefore, slowly, futures contracts evolved to replace them. The first problem is that forward contracts are prone to breach of contract. For example, in the previous example, suppose the general and the farmer agreed to buy 100 taels of rice for 100 taels of silver. Now the price of rice has risen to 200 taels per 100 taels. The farmer is unwilling to sell at the past price. Or if the price drops to 50 taels per 100 taels, the general is unwilling to pay the high price in the past. Both parties have the possibility of breach of contract. To prevent this situation from happening.
We need a third party to be fair. Therefore, futures exchanges were born. Futures exchanges bear the risk of breach of contract. No matter what the price is after one year, the futures exchange will sell 100 taels of rice to the general at 100 taels and purchase the same weight of rice from the farmer at the same price. Why can the futures exchange do this? Because there are thousands of generals and farmers trading on the futures exchange at the same time. Individual breach of contract events will not affect the operation of the futures exchange. At the same time, everyone knows that they need such an exchange. If there is no such exchange, neither the general nor the farmer can properly arrange their own careers.
Of course, the exchange is not eating plain rice. It will charge both the general and the farmer a deposit. If the transaction amount is 100 taels, it will charge 10 taels as a deposit. This deposit is the margin for futures. The futures margin will also fluctuate with the price of rice. If the price rises to 110 taels, the margin will be 11 taels. The exchange always reserves a certain buffer to protect its own interests.
The second problem is that the quality of the goods in the forward contract cannot be guaranteed, so the exchange needs to check it. The exchange will require the farmer to deliver only rice of the quality specified in the contract when fulfilling the contract. For the convenience of calculation and delivery, the exchange will also standardize the contract and specify the unit of each contract.
The third problem is that forward contracts are difficult to transfer. What if a farmer suddenly gets sick and can’t farm after signing the contract? Forward contracts are difficult to transfer. This requires the consent of both the buyer and the seller. But futures contracts are different. As long as someone is willing to take over the contract on the exchange, it can be done.
That is to say, farmer A can sell the contract, take back his margin, and let farmer B fulfill the contract. This is the advantage of the transferability of futures contracts.
Here we take the CME corn futures contract as an example to explain:
For corn futures contracts, corn is the commodity that both parties agree to trade. Since futures contracts are calculated by the number of contracts, the size of one contract for CME-traded corn futures is 5,000 bushels (127 metric tons). The delivery months for CME corn futures are March, May, July, September, and December.
Suppose a buyer and a seller simultaneously trade corn futures contracts on the exchange. The futures contract transaction time is in March, the contract price is $40,000, and the delivery month is December. Then, in December, both parties need to fulfill the contract for delivery. At this time, the seller needs to sell 127 tons of corn to the buyer for $40,000, the price agreed upon in March, regardless of the current market price.
Because the contract is traded on the exchange, even if one party breaches the contract at maturity, the exchange will bear the responsibility for delivery.
The standardization of futures contracts makes it easier for market participants to trade because all contracts follow the same rules and agreements. In addition, the price of futures contracts is usually determined by market supply and demand, so investors can make investment decisions by referring to market conditions. View all futures contracts
02 Leverage effect
Many people believe that futures trading is very risky because of the leverage effect in futures trading.
Futures leverage refers to the fact that investors can control a certain number of futures contracts by paying only a small amount of margin. If you buy in the right direction, your profits will be magnified. However, if you buy in the wrong direction, your losses will also be magnified.
Let’s take a CME Dow Jones mini contract as an example to explain. Suppose an investor wants to buy a Dow Jones mini contract when the Dow Jones index is at 32,900 points. Since the size of one Dow Jones contract is 0.5 dollars times the Dow Jones Industrial Average, the size of this futures contract is 32,9000.5=16,450 dollars. Since futures are leveraged, assuming the margin is 10% of the contract size, the leverage is 10 times. That is, the investor only needs 16,45010%=1,645 dollars to control a Dow Jones mini contract with a size of 16,450 dollars. If the margin is 20%, the leverage is 5 times, and the investor needs 16,450*20%=3,290 dollars to control a Dow Jones mini contract with a size of 16,450 dollars.
In other words, futures leverage trading allows you to use a small amount of capital to control large contracts. If there is no leverage trading, investors would need to spend 16,450 dollars to buy this contract.
Different leverage ratios require investors to have different returns and losses. Taking the previous example, suppose the leverage is 10 times now, and when the Dow Jones index falls to 32,571 points, the investor will lose (32,900-32,571)0.510=1645 dollars. The loss borne by the investor is 100% of his margin, which means he has lost all his money. If the leverage is 5 times, the investor will lose (32,900-32,571)0.55=822.5 dollars. The loss borne by the investor is 25% of his margin.
It can be seen that the larger the leverage, the greater the loss. Once the market fluctuates and deviates from your prediction, it is very likely that you will lose everything. Of course, if the market fluctuates in line with your prediction, you can also get rich overnight. However, it is worth reminding everyone here that high leverage and high risk are two different concepts for futures. The risk of asset prices is not caused by leverage but by the fundamentals of the asset price itself. This is like going to the gym to exercise. We cannot tell a muscular man that a 30 kg dumbbell is riskier than a 3 kg dumbbell. Because for this muscular man, 30 kg and 3 kg are no problem.
However, for children, 30 kg may be too much. For futures, whether the tool has risks is not due to the tool itself, but how people use it.
For futures, position management, and how to avoid liquidation in volatile markets, is the correct way to use the tool. The gym has 30 kg dumbbells, as well as 20 kg, 10 kg, and 5 kg dumbbells, which are used according to different needs. The same is true for futures leverage. There is no need to use 10 times leverage. Similarly, you need to use it according to the situation.
03 Futures margin
Due to the leverage mechanism in futures, investors are likely to face the risk of default when the market experiences severe fluctuations. Therefore, the third point appears futures margin.
Specifically, the margin in futures trading is a certain proportion of the transaction amount that investors must pay to ensure that investors fulfill their trading obligations and is also a certificate for bearing market risks. Both buyers and sellers need to pay futures margin.
The margin will change with the market, and the amount of futures margin is usually stipulated by the exchange. Investors can learn relevant information through the exchange’s website or brokers.
Taking stock index futures as an example, its margin ratio is usually 5% to 10%. That is to say, if the value of a stock index futures contract is 100,000 yuan, then investors only need to pay a margin of 5,000 to 10,000 yuan to control this contract and enjoy the leverage effect.
Different margin ratios correspond to different leverage ratios. The formula for calculating leverage is leverage size = 1/margin rate. If your margin is 5%, then the leverage you enjoy is 20 times. If you pay a margin of 10%, the leverage you enjoy is 10 times.
When the margin is raised, it also means that the current market fluctuates greatly. Often at this time, the market performance is relatively poor. If investors do not have enough margin when the market reaches its worst, they will be forced to liquidate by the exchange. This is equivalent to losing all the chips at the gambling table and there is no way to turn over. This needs to be prevented.
In summary, the higher the leverage, the lower the amount of margin required, the greater the market volatility, and the greater the risk. Conversely, the lower the leverage, the higher the amount of margin required, the greater the margin rate, the smaller the leverage return, and the smaller the risk.
04 Futures positions
The fourth point of futures trading is futures position, which refers to the number of contracts held by investors in the futures market.
There are three important aspects of position holding. First, futures can be long or short. Therefore, futures positions can be long or short. Short means no goods. In futures trading, there are certain restrictions on short selling, such as not being able to actively trade with buy orders, and must wait for sell orders to match.
Second, there is a buyer for every seller in the market. If you buy one futures contract, there will be a seller selling one to you. From a monetary perspective, this is a zero-sum game. You earn the money that the other party loses. This concept will prompt us to think about what mistakes our trading opponents are making before opening a position.
Of course, there are exceptions to the above, such as your trading strategy is hedging, or there are individual futures traders who trade the replacement of cycles. When they open a position, they do not think about whether their opponents are making mistakes, but the expected trend in the future months or even longer.
Third, the change in position is one of the indicators of market turning. Because the change in the total open interest in the market can reflect the size of the market’s interest in the futures contract. If the total open interest in the market keeps rising, it indicates that both long and short sides are opening positions, investors’ interest in the futures contract is growing, and more and more funds are pouring into the contract trading. Conversely, if the total open interest in the market keeps decreasing, it indicates that both the long and short sides are closing out, and investors’ interest in the contract is weakening.
The increase or decrease in position must be even. For example, suppose there are 100 contracts held in the futures market now, and the latest price is 100. At this time, A buys one contract to open a position, and B sells one contract to open a position. Their bids are both 100. Obviously, after A and B’s transactions, a contract will be issued in the market, and the position will increase by two contracts. Because A and B have both opened positions, the total market position at this time will become 102 contracts.
Another situation is that suppose there are still 100 contracts held in the futures market now, and the latest price is still 100. Now, A wants to sell one contract of his long position to close out, and B wants to buy one contract of his short position to close out. If A and B both bid 100, their orders will be matched. At this time, there will be one less futures contract in the market, and the position will decrease by two contracts. Because A and B are both closing out, the total market position at this time will become 98 contracts.
05 Futures delivery
The last element of futures trading is futures delivery.
In the futures market, there are two ways of futures delivery: physical delivery and cash delivery.
Physical delivery refers to the seller delivering the corresponding goods according to the quality and quantity specified in the futures contract to the exchange-designated delivery warehouse, and the buyer paying the corresponding payment to the exchange. The ownership of the physical goods will be transferred. Physical delivery is usually applicable to commodity futures, such as soybeans, gold, etc.
During physical delivery, natural persons (ordinary investors) cannot participate in delivery. In addition, positions that are not integer multiples of the price unit are not allowed to be delivered. The cost of physical delivery will also increase, such as delivery costs, transportation costs, and brokerage fees.
Cash delivery refers to the calculation of the value of the futures contract based on the futures price on the delivery date, and the payment is made in cash to the investor, without involving the transfer of physical goods. Therefore, cash delivery can also save a lot of costs. Cash delivery is usually applicable to financial futures, such as stock index futures.
It should be noted that because market prices differ, investors may experience losses or profits during cash delivery.
In most futures trading, physical delivery is not carried out, and contracts are completed through cash delivery. This is because physical delivery requires sellers and buyers to have corresponding logistics, warehousing, and delivery capabilities, while cash delivery is more flexible, low-cost, and more in line with actual market demand. In addition, most transactions in futures trading are closed out, that is, investors holding futures contracts can choose to trade in the opposite direction in the market before the contract expires, thereby avoiding physical delivery.
In summary, futures delivery is the process that must be fulfilled when the futures contract expires in the futures market. Investors need to understand the delivery methods and regulations of futures contracts in order to make corresponding investment decisions. Risk and Disclaimer Statement:
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