What are Futures?

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Futures are a type of financial instrument under which parties agree to buy and sell an asset at an agreed price on a specified future date. When that date arrives, the buyer must buy the asset and the seller must sell the asset at the pre-agreed price, regardless of the current market price. 

Futures are available over a wide range of assets, including physical commodities and ASX shares. Commodity futures are one of the oldest forms of futures contracts in the world. Today, futures are available for an enormous range of commodities, including gold and other metals, grains, oil, energy, and even livestock. 

What are futures used for? 

Futures can be used to speculate on the future price of an asset, or hedge a current asset position. For example, if you believe the price of Zip Co Ltd (ASX: Z1P) will increase, you may enter into an ASX futures contract to buy Zip shares at a specified price on a future date. If the market price of Zip shares is higher than the specified price when your ASX futures contract matures, you will make a profit.

Commodities companies use futures to hedge the price of their raw materials, protecting against adverse price movements. By using futures to lock in the future price, the company is protected if the price of the commodity falls. But the downside is that if the price increases, the company loses that windfall. 

Options vs futures 

Futures differ to options in one important respect – under an options contract, the holder has the right to buy or sell the underlying asset but is not obligated to do so. Under a futures contract, the holder is obligated to buy or sell the underlying asset. This difference makes futures riskier, as losses are potentially unlimited.

For example, suppose you thought the S&P/ASX 200 Index (ASX: XJO) was set to crash and you entered into an ASX futures contract to sell the index at a low price. If the ASX 200 boomed instead, you would be obligated to sell at the low price, losing the difference to the current market price. 

Should futures be part of your investment strategy?

ASX futures can be used to hedge ASX shares as well as to speculate on price movements. Futures are a derivative financial contract, however, so should only be used by investors with a strong understanding of the underlying risks.

Many retail investors avoid trading in futures due to their complexity and the associated risks. But the ASX futures market offers a wide variety of futures, including sector and index futures, which allow investors to take a position on the market as a whole, or specific segments of it. You can use ASX futures charts (such as the S&P/ASX 200 Index Futures Chart) to gauge investor expectations of where the market is heading. 

How to buy ASX futures 

If you decide futures should be part of your investment strategy, you will need to know how to buy them. In order to open a futures position, you can place an order with your broker to either buy or sell futures contracts. You will then be matched with another market participant. You must pay an initial small margin to establish your position. Then you will either pay or receive variation margins as the price of the contract varies.

You can hold your position until your ASX futures contract matures, or you can choose to close out early. To close out early, you’ll need to buy futures with the same maturity date (if you previously sold them) or sell futures if you previously bought them. This effectively cancels out your open position. 

What are the pros and cons of using futures? 

The benefit of futures contracts is they allow you to lock in the price of an underlying asset, such as an ASX share, in advance. The disadvantage is that the market price may not move in your favour, meaning you will be out of pocket when the futures contract matures. 

Futures provide leveraged exposure to the underlying asset, as investors are only required to put down a small margin initially. This means futures can be risky. ASX futures provide a valuable resource to those looking to hedge positions or speculate on the ASX, however it can take significant experience and knowledge to trade them successfully.

Nonetheless, it’s important to consider all options when you’re building your investment strategy. If you’re ready to branch out, futures may have a place in diversifying your portfolio.

Updated as of 5th August, 2021. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and has recommended ZIPCOLTD FPO. The Motley Fool Australia has no position in any of the stocks mentioned. Motley Fool contributor Kate O’Brien owns none of the shares mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.