In Hong Kong, futures are popular investment instruments. Some investors see futures as high-risk leveraged investments. For others, they're protection against dramatic price changes.
What are futures?
Futures contracts are derivative instruments. A stock futures contract represents a commitment to buy or sell a predefined amount of the underlying stock at a predetermined price on a specified future date.
When you buy a stock futures contract, you are holding a long position and have to buy the underlying stock on the final settlement date. However, you can choose to hold a short position by selling a stock futures contract - this means that you have to sell the underlying stock according to the contract terms. (Note)
Remember though that not all futures contracts are linked to a product that can be physically delivered. A stock index futures contract, for example, is generally settled for cash.
Do futures contracts have common characteristics?
Despite the diversity in futures contracts, they do share some common features. Also certain terms are frequently used in many exchange-traded futures contracts:
- Underlying asset: Assets underlying futures contracts can be quite varied. They include stocks, indices, currencies, interest rates, commodities, such as oil, beans and gold. HKEx futures contracts are financial futures mainly based on interest rates, gold, stocks and stock indices such as the HSI, H-shares Index.
- Contracted price: The price at which a futures contract is registered by the clearing house, i.e. the traded price.
- Contract multiplier: The weight that is multiplied by the contracted price when calculating the contracted value. With HSI and H-Shares Index futures, the contract multiplier is $50 per index point, whereas in a mini-HSI futures contract, it is $10 per index point. For HKEx stock futures contracts, this is one board lot of the underlying stock.
- Last trading day: The last day when a futures contract can be traded on an exchange.
- Final settlement day: The day when the buyer and the seller must settle the futures contract.
- Final settlement price: The fixed price determined by the clearing house and used to calculate the futures contract's final settlement value. Multiplying the final settlement price by the contract multiplier gives the final settlement value.
- Settlement method: A futures contract can be settled by cash or by physical delivery of the underlying asset. All futures contracts traded on the HKEx (except for Three-year Exchange Fund Note futures) are settled in cash.
Why do investors trade futures?
Generally, there are three main reasons for trading futures: directional trading, hedging and arbitrage.
If you expect the stock market to rally, you can opt for directional trading by buying a stock index futures contract. You make a profit if the final settlement price is higher than the contracted price when you bought the futures contract. On any day on or before the last trading day, if the going price of the index futures is more than the contracted price, you can realise your profit by selling the same futures contract to offset your original long position. On the other hand, if you think the market will fall, you can sell a stock index futures contract.
Hedging strategies are commonly used to offset any negative effects on an investor's portfolio return. If you want to mitigate your loss in a falling market, then you can use a short hedge by shorting a stock futures contract. Or you can apply a long hedge to lock in the buying price for the underlying stock on a future date by buying a stock futures contract. If the stock price rises, you will be able to buy the stock for less than the going market price.
If you are trading in futures, you must remember to pick futures contracts in which the underlying assets correspond to your holdings. For example, HSI futures are not the ideal tool to hedge red chips which are not HSI constituent stocks.
Arbitrage allows you to earn profits by capitalising on unusual price discrepancies between the futures market and the underlying cash market. You can do this by executing opposite trades simultaneously in the two markets.
Leverage can be bad for your financial health!
Whatever your reasons for trading futures, remember they are leveraged investments. Both market gains and losses are magnified.
How does this work? Consider a stock futures contract on Stock A which has a contract multiplier of 400 and requires an initial margin of $2,000. If the contracted price is $84, the leverage of that futures contract is about 16.8 times ($84 x 400/$2,000). Should the price of the futures increase by 10%, i.e. a rise of $8.4, your investment return will be 168% ($8.4 x 400/$2,000 x 100%). However, if the futures price falls, your loss will be magnified 16.8 times!
While futures trading can make substantial profits, it can also lead to equally significant losses in a short period of time. Futures trading is only for sophisticated and more disciplined investors who can afford potential losses should he find himself on the wrong side of a market.
Other futures trading terms
- At a premium: The futures contract's going price is higher than that of the underlying asset.
- At a discount: The futures contract's going price is lower than that of the underlying asset.
- Rollover: A client who has an open position in a futures contract approaching its last trading day closes that position and opens the same position in a futures contract with a later expiry date.
Note: In Hong Kong, stock futures contracts are settled in cash. There is no physical delivery of underlying stocks on the final settlement day.