What are futures and who needs them?
The stock market of Ukraine is not full-fledged, because it does not have many of its instruments. In this case, we are talking about futures and options. However, this does not mean that you need to be in the dark and wait for them to appear.
Most stock traders today prefer to work with them, rather than speculating with the securities of companies.
A futures contract is a security that imposes an obligation on the participants of a transaction to buy/sell any asset after a certain period of time at a pre-fixed price.
Options and futures refer to derivative financial instruments, and they are also commonly referred to as derivatives. By purchasing them, you do not become the owner of securities, currency, raw materials, oil or other minerals, but you get the opportunity to purchase them or sell them at a fixed cost in the future. In simpler words, you insure yourself against unregulated changes in asset prices. Initially, derivative financial assets were created exclusively to reduce the risks of producers.
Let’s explain with some examples:
1) The Sweet Sugar company grew beets and produced sugar. For her, sugar is the underlying asset. The company plans to purchase new equipment and wants to be sure that it will be able to recoup the investment. “Sweet sugar” can conclude a contract on the stock exchange for the sale of 10,000 kilograms of sugar at a price of 100 hryvnia per 1 kilogram in 7 months. It turns out that the contract execution date falls on October 1. By this time, the company will have already collected a new crop of beetroot, processed it and will be able to deliver the finished product to the buyer. This future contract is called a futures contract. Thanks to it, the company will be able to sell 10,000 kilograms of the underlying asset and earn UAH 1 million. This means that the company gets the opportunity to forecast its own revenue. Yes, and the buyer of “Delicious candy” also has the opportunity to predict their future costs for the purchase of sugar.
It often happens that when the delivery date arrives, the price of the underlying asset increases, in which case the Sweet Sugar company loses a certain benefit. However, if the price of the product decreases, the security will fully justify itself, since at a low cost, the Sweet Sugar sales company would suffer losses.
2) A farmer sowed corn in Poltava in the spring, the cost of grain on the market at this moment is 7500 hryvnia per 1 ton. If you believe the forecasts, then the summer should be ordinary and not dry, and therefore the farmer relies on the fact that there will certainly be a good harvest in the fall. As a result, the supply of grain on the market will increase and, consequently, its value will fall. Naturally, the farmer has absolutely no desire to sell corn in the fall at 6000 hryvnias per ton, so he finds a buyer and guarantees him that he will deliver 100 tons of grain at the current price in six months. In this example, the farmer is a futures seller, and he is trying to predict his income in the future. However, the situation in autumn may be quite different, for example, the price of corn will rise to 9,000 hryvnia per ton, and then the farmer will lose, because he will not receive income. If the price drops to 6,500, the futures contract will pay for itself entirely, since at this price the farmer would have suffered losses. The role of the contract buyer can be assumed by a feed mill, which also predicts future expenses for the purchase of raw materials. A private investor will be interested in corn futures only if they need to determine the cost of this type of raw material in advance.
As a rule, the price of futures depends on the prices that have developed for fundamental assets in the stock market. Therefore, it is a PFI that can be both bought and sold, but only on the stock exchange. You can perform operations during the entire period of their “expiration”, that is, from the date of conclusion of the contract until its execution.
Private investors can also benefit from PFI’s, as they get the opportunity to fix the price for the purchase or sale of valuable assets, currencies, precious metals, etc.In simpler words, derivatives allow stock exchange participants to earn on assets that a simple investor cannot buy directly. One of them is oil.
There are classic and non-deliverable futures. Classic means a contract for the sale of an asset at a set price with deferred payment. In other words, the contract fixes the quotation at which the parties to the transaction must fulfill their obligations after a certain period of time – 3-6 months, etc. Naturally, during this period, the quotation for it can change dramatically, but it obliges the participants to complete the transaction by the specified deadline at the price specified in the document.
Non-deliverable futures are defined as monetary settlements. This means that the seller is not obligated to make a physical delivery of the asset on the expiration date of the security, and the buyer does not have to purchase it. Participants in the transaction can close the contract at any other time, but in this case they will not be able to predict revenues and costs. If all the terms of the transaction are met by the deadline, the seller will receive the amount specified in the contract on the day of the end of the futures contract, and the buyer will spend the same amount on the purchase.
More recently, the purchase of futures was understood as the fact that the buyer will receive an asset on the appointed day, while the exchange dealt with the delivery of goods. This means that the buyer of sugar “Yummy candy” 10 years ago would have received 10,000 kilograms of product under the contract from “Sweet Sugar”.
Currently, most production financial instruments have a non-deliverable form. This means that on the day of expiration of the contract, the seller no longer gives real assets to the buyer, and the settlement between the participants in the transaction is made in cash using a derivative. What does it mean?
The Sweet Sugar company expects to receive UAH 1 million for 10,000 kilograms of sugar sold. And the Yummy Candy factory agreed to this price. Under the terms of the non-delivery futures contract on October 1, Sweet Sugar does not ship sugar to Yummy Candy; instead, it can sell its products on the commodity exchange to anyone who wants and deliver the goods to the nearest warehouse accredited by the exchange. Yummy Candy can also buy sugar on the stock exchange from any seller and receive products from an accredited warehouse.
At the same time, the exchange price of sugar as of October 1 may differ from that fixed in the contract. For example, it can fall to 80 hryvnias for 1 kilogram. This means that “Sweet sugar” will be able to get only 800 thousand hryvnias. But in addition to this amount, “Yummy Candy” will pay “Sweet Sugar” under the contract 200 thousand hryvnias-the difference that was formed between the futures price and the current exchange price. As a result, “sweet sugar” will receive 1 million hryvnias, as planned.
Yummy Candy can also buy 10,000 kilograms of sugar at the same market price – for 800 thousand hryvnias. Since it will need to pay “Sweet Sugar” 200 thousand hryvnias for futures. In total, she will incur expenses of 1 million hryvnias, which she planned.
If the exchange prices are higher than those set in the futures, then the opposite will happen. “Sweet sugar” will need to pay “Delicious candy” the resulting difference. No matter how the situation develops, thanks to the securities, Sweet Sugar will receive 1 million hryvnias, and Delicious Candy will pay them.
The stock exchange publishes a list of offers coming from market participants. As a rule, they have slight deviations in price. Offers are visible to all exchange participants in a special program.
For each contract, the exchange assigns a specification, which describes the main positions of the contract, namely: name, symbol, variety, size of one futures contract, validity period, minimum price fluctuation step and step quote.
Such contracts are concluded only on the exchange. Also, the seller can independently put up his offer, specifying the price and period of validity of the contract, and wait for the buyer’s response, who considers these conditions suitable. The buyer can also leave a request and specify the conditions in it, and the seller can choose from the list the one that best meets their wishes in terms of price and quantity.
As soon as the contract is concluded between the seller and the buyer, the exchange will monitor its implementation. What does it mean? If the value of the asset falls in the future, then according to the rules, the buyer would have to give the seller a certain amount. However, in reality, this does not happen, this issue is decided by the exchange. As an intermediary in the transaction, the exchange itself makes deposits and debits funds from the accounts of bidders. If the quote increases, then again the exchange is engaged in fulfilling its obligations under the security to the buyer. In this case, we mean a non-deliverable type. If the futures contract is a classic one, then deliveries on it will be guaranteed by the insurance company.
Even if the seller does not want to pay or the buyer does not have enough money in the account, the futures contract will still be executed by the exchange at its own expense. As an intermediary, the exchange also takes risks, so it requires participants who have entered into a contract to deposit a deposit into the exchange’s account. The collateral amount is calculated by the exchange using special formulas that cover many indicators, in particular, changes in the price of an asset in the previous period. How to understand? If during the past year the price of an asset has changed by 5% as much as possible, the exchange will take a deposit of 10% of the quote.
A futures contract can be implemented at any time before the expiration of its validity period, this is not prohibited by exchange trading. Every day, the exchange that issued it recalculates the price. Thus, it determines the price at which you can buy or sell a futures contract. Each exchange has its own calculation rules based on the quotes offered by market participants. This means that if the price starts to rise, it will be followed by an increase in the futures purchase price, since the contract value cannot be less or greater than the asset price.
1) In the spring of last year, oil futures prices suddenly fell so much that they were in the negative zone. This is explained by the fact that mostly classic contracts were concluded. The buyer has assumed the obligation to pick up the previously agreed amount of oil. Because of the pandemic, naturally, oil ceased to be in demand, producers did not have time to adjust the volume of its production, there were no places for storage — all these factors provoked a drop in prices for “black gold”.
2) You have purchased a delivery futures contract for commercial bank shares with a validity period of 6 months at UAH 5,000 per share. After 6 months, the broker will write off futures from your account and credit the bank’s shares that you purchased, regardless of the current quote on them. If you purchase a settlement type, you will not receive any shares to your account. The broker calculates the difference between the price and the current quote of the asset and deposits it to your account. In other words, if the share price is higher than 5 thousand hryvnias, then you will receive the difference to your account. If the shares fall in price, the difference between their quotes will be your loss, and it will be debited from your account. Thus, the first option is suitable for those who really need bank shares, and the second-for those who want to earn income on asset speculation.
Despite the fact that futures is a security, it has some features. Its owner cannot influence the activities of the company from which he purchased this contract, since the futures contract is not tied to the company’s ownership. In addition, it is not a means of long-term investment, it always has a certain maturity date. It brings profit to some participants of the transaction, and losses to others.
Futures don’t have coupons or dividends, unlike stocks and bonds, but they can be purchased cheaper and sold more expensively. Traditionally, most of them end on the third Thursday of each month, and on Friday they are already closed.
Due to these differences from traditional securities, futures today attract more and more stock speculators. This is due to the fact that they can earn money on different market features. Also, trading them is not very burdensome with taxes and other payments. Brokers of many exchanges offer participants attractive lending conditions for such transactions. Hence the conclusion that futures are an excellent solution for diversifying your investment portfolio.
Thus, they are a convenient PFI that helps reduce long-term financial risks.
What are futures and options?
If a futures contract is a contract for the purchase or sale of an asset, then an option is the same contract, but only for the right to buy/sell the asset at a specified price at a specific time in the future. However, it is not necessary to exercise the right; in this case, it should be evaluated as an opportunity to perform a profitable operation. In other words, the buyer of the option can withdraw from it at any time if he understands that there is no benefit in the transaction, but the seller will have to fulfill the terms of the contract to the end.
Options are traded only on the exchange. These contracts are very popular with buyers, due to the fact that they are well insured against possible losses. The buyer, having refused the transaction, loses an insignificant amount of funds, which will be credited to the seller as a bonus. But such a ” sacrifice” will save him from significant losses.
Futures and options are bought and sold on the stock exchange for the entire duration of their validity. Stockbrokers with experience, of course, make good money on speculative operations with valuable bcmags, but it is still better for a novice investor to use these tools in order to insure possible financial risks.
Based on the definitions we gave above, you probably already understand what the difference is between an option and a futures contract. If not, then we remind you that with the purchase of an option contract, the buyer receives only the right to purchase assets at a specific price at any time of the contract, and the right is not an obligation.
A futures contract, on the contrary, insists that the buyer buy the asset and the seller sell it on the date set by the transaction, provided that the holder’s position is opened before the contract execution date.
The difference between a futures contract and an option is the rights and obligations of the parties to the transaction. If at the conclusion of a futures contract, the participants in the transaction have the same rights, then the situation is different with the option, the right is on one side, and the obligation is on the other.
At first glance, it may seem that the option is imposed on those who get the obligations, since it is not known whether the buyer will want to use his right in the future or not, whether he will complete the transaction by the deadline or refuse it.
To counterbalance this disadvantage, a premium is introduced, which is the fixed reward of the option seller for this uncertainty. Whether the transaction is completed or not, the reward will remain in any case. The premium amount changes throughout the entire trading session and is calculated by the exchange.
1) Your neighbor wants to sell a car for 10 thousand dollars, you leave him $ 200 as a deposit and tell him that you want to buy a car in 1 month. However, when a pre-agreed date occurs, you change your plans. Naturally, you apologize to the seller and do not demand a refund of the deposit amount in return. In this situation, $ 200 is the premium for a call option, $ 10,000 is the strike price, and 1 month is the exercise period of the option.
Despite the differences between futures and options, they have many things in common. Futures and options are:
- PFI’s that focus on the underlying asset;
- unified instruments that have a specific specification formulated by the exchange;
- fixed-term contracts with an execution date;
- the ability to engage in speculation and risk insurance.
These assets have a rich past, and initially these funds were created to reduce risks.
The asset in this case is a futures contract. The option buyer acquires the right to take a specific position in the futures contract at a specified strike price at any time before the option expires. The subject of the transaction can be futures for any asset-commodity, stock indices, currency. The seller is “obligated” to execute the futures contract, provided that the buyer exercises its right to exercise the option. Futures options are traded on the same terms as futures contracts. Namely, the option futures are compared with the underlying contracts, and the asset size, expiration time, and strike price execution are taken into account.
There are several differences between options on futures contracts and futures. The main difference is that the participants in the transaction have different responsibilities.
Under a futures contract, the buyer undertakes to purchase a specific asset within the specified time limit, and the seller undertakes to perform the sale and delivery on the expiration day, with the exception of those cases when the holder closes positions ahead of schedule. In other words, the contract does not imply an initial payment of the cost. As a rule, the size of the underlying asset in a futures contract is larger than in an option contract. Contract income is added every day when trading ends on the exchange. This means that its price reflects the current market value.
The buyer gets the right, but not the obligation, to buy or sell a particular asset at a pre-determined price. This right can be used at any time before the expiration date of the contract. You can buy options and futures after paying the premium. The size of the underlying asset is lower than in a futures contract. You can earn income on an option only if you exercise it at the moment of greatest profit. Usually in this situation, a hedging technique is used, in particular, the opposite position is engaged, the option is held until its expiration date. As a result, the difference between the asset price and the strike is formed – this is the profit on the option.