Also Read: Futures Contracts 101 – understanding the basics
Tara asked Jay to explain how speculators use futures contracts, and Jay took a deep breath before he began. “Speculators are traders who try to predict the future direction of prices and profit from it.
They can be anyone from hedge funds to individual investors. They use futures contracts to speculate on the future price movements of commodities, currencies, and financial assets.”
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https://economictimes.indiatimes.com/newslist/54363265.cmsTara nodded in agreement, “So, what is the advantage of buying and selling futures instead of the underlying assets?”
Jay replied, “Well, the main point that attracts traders to futures is leverage.
Futures are a leveraged instrument, meaning you have to pay only a fraction of the total money. This amount is called a margin, a form of collateral traders must deposit to open a position. Margin requirements vary depending on the contract, market volatility, and exchange, but are generally set at a percentage of the contract’s value. This allows traders to amplify their returns by controlling a large number of assets with a relatively small amount of capital.”Tara raised a valid point, “But isn’t the risk also higher in case of an adverse move?”
Jay agreed and cautioned, “Indeed, futures trading is a complex undertaking and requires expertise in risk management. There have been notable instances in the past that highlight the significance of managing risks effectively.”
Tara expressed her interest, “Oh, I always find stories and events to be fascinating.”
Jay continued, “One of the most famous events in the futures market was the Hunt Brothers’ attempt to corner the silver market in the 1980s. The Hunt Brothers, wealthy oilmen from Texas, began buying up silver futures contracts and physical silver in an attempt to drive up the price of silver. At one point, the price of silver rose to over $50 per ounce, a huge increase from its normal price of around $10-$15 per ounce. However, the US government stepped in and implemented new regulations to prevent market manipulation, and the price of silver eventually crashed, causing the Hunt Brothers to lose billions of dollars.”
Tara’s eyes widened, “Wow, that’s quite a cautionary tale!”
Jay continued, “That’s why it’s essential for speculators to manage risk with stop-loss orders, which automatically close out their position if the price reaches a certain level. They also need to stay updated with the latest news and events that may affect the market and adjust their trading strategies accordingly.”
Dev, an observer of the conversation, also interjected. “There is another point where futures trading helps. In some exchanges, like in India, you cannot short security beyond Intraday. But you can trade futures from both directions and can carry positions beyond a day. Traders can make money by going long (buying futures contracts at a low price and selling them later at a higher price) or by going short (selling futures contracts at a high price and buying them back later at a lower price). In either case, you are not required to have possession of the underlying asset.”
Tara exclaimed, “I now understand why speculators are drawn to futures trading!”
Jay smiled, “Not only the traders, but the market also benefits from these speculators. Speculators play a vital role in the market because they help provide liquidity, making it easier for producers and consumers to hedge their risks. By taking the other side of the trade, speculators help stabilize the market and reduce the volatility caused by sudden changes in supply and demand.”
As Tara grasped the intertwined nature of traders and the market, she couldn’t help but wonder about the limitations of futures contracts. “Jay,” she asked with bated breath, “since futures contracts come with an expiration date, how can I extend my position beyond a mere few months or years?”
Jay quickly responded, “When you trade futures contracts, you need to keep in mind that they have an expiration date. Before that date, you have two options: either close out your position or roll it over to a new contract with a later expiration date. Rolling over involves closing your current contract and opening a new one with an extended expiry date.”
Tara nodded, understanding the basics. “Got it. But how do you use futures for long-term analysis in charts? How do traders handle chart gaps caused by rollover?”
Jay smiled, impressed with Tara’s inquisitive nature. “That’s a good question. You can analyze futures using technical analysis, just like you would with stocks. This could also involve looking at charts and identifying patterns to make trading decisions. You can also use various indicators and charting tools to identify trends, support, and resistance levels, and other key data points.”
“But when traders analyze futures data that covers multiple contract expirations, they use two methods to make sense of all that information: perpetual contracts and continuous contracts,” Jay explained, feeling proud of Tara’s progress.
Jay continued, “Perpetual contracts, or constant forward contracts, use a formula that combines the prices of the two nearest contracts and gives more weight to the one that’s closest to the forward date, say 60 days from today. With each passing day, the weight of the current expiry reduces until the expiration day when the next expiry becomes the current expiry, with the next expiry added, and again, the weight of the current expiry starts reducing. This gives a smooth contract price eliminating gaps at rollovers, but because it’s not a real contract that was traded, it doesn’t always match the price patterns of actual contracts.”
Tara asked, “So, what are continuous contracts?”
Jay continued, “The other method is a continuous or spread-adjusted contract. This contract begins at some time in the past with prices of a current contract. A rollover date is determined based on the trader’s usual turnover date, say 10 days before expiration. The spread between contracts is accumulated and finally, a cumulative adjustment factor is determined based on which continuous contract price is adjusted.”
Tara nodded, trying to follow along. “I understand that neither of them will match the actual contract price, but which one of these two is more realistic?”
Jay explained, “Continuous contracts are more realistic. Imagine a trader who wants to analyze the price trend of crude oil futures for the last five years and also wants to backtest the system and strategy. He can use a continuous contract that combines the prices of each crude oil futures contract for the past five years. Price trends and formations will occur in continuous contract charts as they would have in actual price charts at that time. Also, the continuous contract will reflect the actual costs if the trader had rolled over their position at the rollover date.”
“Only issue, as you stated, is that due to accumulated spread, the actual price of the contract might differ a lot, and so do the percentage change.”
Tara thanked Jay for explaining the difference between the two methods of splicing contract prices together in a way that was easy for her to understand. She felt grateful for the wealth of knowledge Jay and Dev had shared with her. “Thank you both so much for explaining all of this to me. I feel like I’ve learned a lot.”
Jay smiled encouragingly at Tara. “Remember, Tara, futures trading is not a shortcut to overnight riches. But if you do it right, it can help you manage risk and generate solid returns. Just make sure you do your research and always keep risk management at the forefront of your mind.”
The three of them wrapped up their exhilarating discussion on the future. As Jay said goodbye and exited the conference room, Dev and Tara eagerly looked forward to their next meeting with a colleague who would introduce Tara to the exciting world of options trading.
(The author is CEO TradingHeads.com, Yubha.com)
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