What is a future or forward contract?
Futures are forward contracts that are not linked to conditions. This means that they contain an obligation that must be fulfilled in any case and are not linked to specific conditions or simple exercise rights like options. With futures you can, for example, buy or sell an index or a commodity today at a certain time in the future. Since futures are traded continuously, positions can also be liquidated daily during the usually very long trading hours on the market, with profits or losses depending on the entry price.
Who trades futures?
Futures are a low-cost and usually very liquid trading instrument for institutional investors and professional traders during official trading hours. In other words, these instruments are only traded by real stock market professionals. Traders who want to trade futures should be aware of this and know the specifications of the contracts. In particular, the often high nominal value of the individual contracts should be taken into account.
A simple example
Let’s take the DAX as an example. Here, each point corresponds to an equivalent value of 25 euros. If one buys a contract at 12,000 points and sells it the next day at 12,100 points, the result is a profit of 2,500 euros. The opposite is also true for a short position, which in this case would result in a loss of the same amount. In addition to the DAX future, there is also the smaller Mini DAX future, where each point is the equivalent of 5 euros.
Margin and leverage
To take a position on futures, you do not have to hold their entire nominal value in your trading account. Instead, only a much smaller margin needs to be deposited. This creates a leverage effect that makes it possible to take large positions with relatively little capital. In a simplified example with an assumed margin of 10%, only 30,000 euros would have to be deposited for a DAX future at a price of 12,000 points instead of 300,000 euros. In practice, the margin is even lower than in this example. According to the mark-to-market principle, the book profits or losses are then continuously balanced at the end of each day (valuation margin).
It often happens that the next expiration month has a slightly higher price than the previous month that is about to expire. As a result, all other futures contracts that are even further in the future usually have even higher prices. This is the normal state of a positive maturity curve, also called contango. The main reason for this is the “carrying costs”, which we will come back to later. Since in a contango situation, when a long position is rolled, the low-priced future is sold and the high-priced future is bought, there is a cost when a position is rolled.
Unlike shares, futures contracts cannot be held permanently. Each contract has a maturity date when delivery of the underlying asset or cash settlement is expected. If you want to maintain your investment, you must first close out the position and unwind it into one of the subsequent contracts, realising gains or losses and incurring transaction costs. When renewing a position, the maturity date of the next month is usually ideal for the new position as it offers the highest liquidity.
Contango and backwardation
However, it can also happen that this structure is reversed. This is the case, for example, if there is a severe supply shortage of a commodity in the short term. If the rather rare case of such a reversal occurs, it is called a shift or backwardation. Here, a profit is made on the rollover of a long position because the current contract with a high price is sold and the next contract with a low price is bought. This example shows that in addition to the carrying costs, current market conditions and market participants’ expectations of future prices also play a role in the price curve.
The Carrying Cost
This factor literally corresponds to the cost of “carrying” the position over time until the maturity of the futures in question. This formulation already makes it clear what it can include. Classically, for commodity futures, for example, it is the cost of storing the physical commodity until the delivery date.
Carrying costs are defined as follows:
Carry Cost or Basis= Spot Index – Future Price.
For indices such as the DAX, on the other hand, it is the financing interest that accrues during the term of the contract that makes up the carrying costs. At present, for example, the DAX future is even slightly lower than the DAX due to the short-term negative interest rates. In the case of futures on equity indices such as the Euro Stoxx, which are not performance indices, the dividends accrued during the term of the shares included in the index are also deducted. This can result in the future trading below the current cash index – especially if a particularly large number of dividends have accrued during the term of the corresponding contract.
The simplified calculation formula is therefore as follows:
Theoretical price of the future = underlying + financing costs – dividend payments.
“Theoretical” because in practice the actual price is determined by supply and demand. Deviations can therefore occur in the course of trading, especially in turbulent market phases. However, since some market participants engage in index arbitrage by trading the actual basket of stocks against the future, the largest deviations quickly stabilise.
The closer the maturity date of the future, the lower the carry costs. This effect, known as convergence, is caused by the fact that the carry costs relate to a shorter and shorter remaining term. On the maturity date of the future, the basis is then zero, so that the price of the future is equal to the price of the underlying asset.
Futures are an instrument aimed at experienced traders. Investors without extensive trading experience should first start with small positions in CFDs, try futures on a demo account and then trade only mini futures. Experienced traders looking for a liquid trading instrument with high leverage often turn to futures. However, it is important to stress that futures do not guarantee that you will make a profit. It requires expertise and diligence to be successful.