CHAPTER 3:

PRINCIPLES OF FUTURES

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OUTLINES

 Definition and Types

 Physical Delivery vs. Cash Settlement
 Principles of Hedging and Speculation
 Trading Practicalities

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DEFINITION

 A future contract can be defined as a contract to buy or sell a specified security at

a specified price and time.
 Legally, every futures contract must be opened today and closed-out later.
 The buyer and seller are obligated to fulfill their futures contract at a maturity
date according to the terms specified today.
 Every contract must have a maturity date or expiry date, which requires both
parties to meet their obligation.

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 BASIC REQUIREMENTS FOR A VIABLE FUTURES
MARKET
Deep Market
 Every futures market must have sufficient
number of buyers and sellers in order to
provide continuous opportunity for trade.
Easy Grading
• Since the focus on agricultural
product, the commodity
selected for trading has to be
easily graded and hence
standardized grading.
Free Fluctuation
 Prices must be free to fluctuate without
any government control or monopoly
power. Prices volatility leads to higher
risks for buyer and seller.
Active Participation
• Business communities must be ready to
participate actively and regularly in order
to provide sufficient liquidity in the
market.
• Producers and consumers of
commodities must be committed to the
use of futures as a means to protect their
position in the cash market.
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 CONTRACT SPECIFICATIONS
• Traded in standardized contracts and at organized exchanges.
▪ Standard contract are subject to the terms and conditions of BMDB
Underlying instrument
Every futures market must have its cash
market. E.g. FCPO with physical palm oil.
Price Quotations
• Futures price are quoted in the same basic
unit as its underlying instrument. E.g. physical
palm oil is RM per tons; CPO futures prices
is also RM per tons.
Contract Month
• Futures contract is traded based on
specified contract month, which is simply
the month of maturity or expiry.
Grade or Quality
• Commodity futures are graded on the
technical requirements of physical
commodity; Financial futures are graded on
the quality of the financial requirements.
Contract Size
• It refers to the number of units or amounts
represented by each futures contract. E.g. the
contract size of CPO futures is 25 tons of
palm oil.
Expiry Date
• The expiry date is the last day of trading in
a particular contract month. E.g. the
maturity date for CPO futures is the
15thof the contract month.
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COMMODITY FUTURES VS. FINANCIAL FUTURES
Commodity Futures
 Include agricultural, futures, fertilizer, wood and
metal futures.
 Is based on the tangible physical commodity.
 It has storage value and hence can be delivered
physically.
Both futures require that the buyer and seller fulfill their obligation or close
their contract either by offsetting or settlement.
Financial Futures
 Include currency futures, interest rate futures and
stock index futures.
 Is based on the intangible financial instrument.
 It does not have storage value, and hence cannot
be delivered physically.
 Outstanding contracts are settled by cash
settlement. Both parties are required to settle the
cash differential, that is, the difference between
the opening price (when the contract was opened)
and settlement price (when the contract is expired.
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OFFSETTING FUTURES VS. SETTLEMENT
Offsetting
 Futures contract can be closed-out simply by
taking the opposite position. Any opened
contract can be closed-out prior to maturity by
taking an offset position. A trader who has
buying position can therefore offset his position
by selling, vice-versa.
Settlement
 The settlement of futures contract depends on
the types of futures. E.g. Commodity futures can
be settled through delivery; Financial futures
through cash settlement.
 •Delivering the commodity at expiration means
the seller closes his position by delivering the
underlying commodity as specified and the buyer
receiving the commodity.
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EXAMPLE 1: OFFSETTING FUTURES VS.
SETTLEMENT

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MARKET PARTICIPANTS

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 MARKET PARTICIPANTS

Hedger
 They are directly involved in the business and wanted to protect their business from the variability and
unpredictability of cash prices or price risk.
 Hedgers can manage their price risks easily and effectively by hedging in the future market without any fear
of unfavourable price movements.

Pure Speculator
•Non owner of physical commodity or financial instrument and are motivated by profits based on favorable
price movements within specified period
•Is termed as the RISKIEST group because the trader has only a single position, and hence, exposed to huge
profit or loss
•Active participation of speculators is required in order to provide liquidity to the market -ERIMALIDA
for futures trading
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SPREADER

 Takes two 2 opposite positions simultaneously, that is buying one contract and selling the
other in the futures market
1) Inter market spread Buying and selling simultaneously same underlying instruments and
contract month BUT at DIFFERENT MARKETS Eg Buy May Rubber Futures at BMDB and
sell May Rubber futures at the Osaka Rubber Futures in Japan.
2) Inter month spread Buying and selling simultaneously same underlying instruments and
markets BUT at DIFFERENT CONTRACT MONTHS Eg Buy May FCPO and sell July FCPO at
the BMDB
3) Inter commodity spread trades futures of DIFFERENT BUT ECONOMICALLY RELATED
COMMODITIES at the same market and contract month Eg Buy July CPO futures and sell
July Palm Kernels Futures at the BMDB

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ARBITRAGEUR

 Is arbitraging on the price distortion between cash and futures markets

1) Scalper trades big volume with minimum price changes with several entries and
exits within a few minutes in one day trading
2) Intra day trader trades smaller volume with smaller price changes and one entry
and exit within a day of trading

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 TYPES OF POSITION

1) LONG
 Participants who have bought futures contract are said to have gone long on futures.
 Bullish (buying today at a lower price and expects to sell later at a higher price prior to or at maturity).
 When a trader goes long on commodity futures and he does not close out the contract at maturity, he will
have to take delivery of the physical commodity upon payment of the buying price to the clearing house.
He has to arrange for delivery of his physical commodity from the warehouse to his designated store.

2) SHORT
 Selling futures contract
 Sell higher today, buy lower later

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EXAMPLE: LONG POSITION
Today
Mr. A Buys a futures contract at RM100 today
(opening price), he will close out his
contract when the market favors him.
Later
The future price has risen to
RM120(closing price).
He will receive RM20 (RM120-RM100)
from his broker (assuming no commission
charges upon offsetting his contract)
The future price has fallen to RM80
(closing price).
Will have to settle by cash settlement at
maturity. He has to pay cash price
difference of RM20 to his broker.
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 TYPES OF POSITION

2) SHORT
 Participants who have sold futures contract are said to have gone short on futures.
 Bearish (selling today at a higher price and expects to buy back later at a lower price prior to or at
maturity).
 Example: Assume a trader has sold futures contract at RM150. when the market moves in his
favor and settle at RM140 two days later, he will make profit RM10 per contract, excluding
commission charges.

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MARGIN REQUIREMENT

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EXAMPLE: MARGIN REQUIREMENT

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EXAMPLE: MARGIN REQUIREMENT

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BASIS

 It is defined as the difference between the cash price (spot price) of the underlying
instrument and the futures price (contract).
Basis = Futures Price - Cash Price
1) Contango market or Normal market; Futures price normally traded above the
cash price or premium (positive basis).
2) Backwardation market Abnormal market; Futures price is trading below the cash
price or at discount (negative bas is).

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CONVERGENCE

 Cash and futures prices move in tandem, that is, they are moving in the same
direction, though not by the same amount.
• Both prices will converge at one price at the date of maturity and hence known as
maturity price. Cash and futures prices are expected to converge at maturity date
because any mispricing will lead to opportunity for continuous arbitrage activities.
• The actions of arbitrageurs will ensure the convergence of futures and cash prices.

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 VOLUME AND OPEN INTEREST

VOLUME: Similar to stock market, volume refers to the number contracts traded. In futures
market, volume of trading is defined as the total purchases or sales for a given contract
month.
Open interest:
 is applicable ONLY in futures trading. It refers to the number of outstanding contract for a
given contract month. It is a number of contracts which is yet to be closed out or expired.
(number of buyers and sellers who have their positions –interest still remain open).
 Significant in the futures trading because it can reflect the level of confidence among
investors. (technical analysis need to consider as an additional variable besides price and
volume in order to determine the behavior of investors and prospect of the futures market
for a given contract month.)

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END OF CHAPTER 3
THANK YOU

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