Futures
  Definition | Features of Futures | Types of Futures | Main Functions of Futures Market | Pricing | Advantages of Futures Market | Trading Strategy
Definition

Futures contracts are standardized by the Exchange, in which the buyer and seller agreed and has obligation to settle the contract with the prescribed quantity in a specified time in the future according to the contract terms. The settlement of futures contracts can be in goods or cash and the most actively traded futures in Hong Kong - HSI Futures contracts are settled in cash.  
 
 

Features of Futures 
  1. Standardized Contracts
  2. Central Clearing
  3. Rapid Price Changes - Reflects Market Expectations
  4. Leverage (Margin Trading)
 
 
Types of Futures Contracts

    1. Commodity Futures
      Agricultural Futures: soybeans, cotton, grain, cocoa, pork belly, cattle 
      Energy Futures: oil and gas oil etc.
      Metal Futures: mainly precious metals, gold, silver, copper, etc.
    2. Financial Futures
      Currency futures, interest rate Futures, stock futures and stock index futures

    Currently, the most common futures product in Hong Kong is financial futures. Those available for trading in the HKEx (0388) include: Hang Seng Index Futures, MSCI China Free Index Futures, the Dow Jones Industrial Average index futures and stock futures, three-year Exchange Fund bond futures and HIBOR futures. Among them, the Hang Seng Index futures contracts are the most actively traded.
 
 
Main Functions of the Futures Market
  1. Hedge Portfolio Risk
  2. Arbitrage in Different Markets
  3. Speculative Trading
  4. Price Discovery
  5. Adjust Investment Portfolio and Capital Structure
 
 
Pricing of Futures

Futures and their underlying assets (stock) has a binding relationship. Take index futures as an example, its theoretical value (fair value) is affected by the short-term market interest rate and expected dividend.
Index futures theoretical value = Index * [1 + short-term interest rate - expected interest rate] * days to contract maturity / 365
Under normal circumstances, short-term market interest rate will exceed index dividend yield, which will result in the phenomenon of theoretical value higher than the market price. However, when the constituent stocks in the index are in the payout period, the theoretical value will be lower than the market price as index futures are not entitled to dividends.  


 
 
Features of Trading Index Futures     
  1. Liquidity
  2. Transaction Costs
  3. Synchronize with the Market Return
  4. Leverage
  5. Risk Management
  6. Short Selling Restrictions
 
 
Trading Strategy
  1. Forecast Market Trends
    This is the simpliest form of trading strategy. Take index futures as an example, investors can buy / sell futures contracts according to market outlook and the gain / loss can be reflected on the rise / fall in index. The trading of index futures are in the form of deposits, therefore if the index trend are in line with expectations, its high leverage can have a multiplying effect on earnings (also applies to losses).
  2. Track Indexes and Earn Return
    If investors are optimistic on a certain market, they can purchase representative index futures directly from the designated market and enjoy the returns resulting from the increase in index. For Hang Seng Index, it accounts for over 70% of market capitalization among listed companies in Hong Kong.
  3. Asset Allocation
    Fund or institutional investors can use a long position in index futures to substitute capital to invest in markets temporarily and to offset the position by buying the underlying stock of the index. This can increase the investment flexibility and asset allocation speed.
  4. Adjusting Investment Portfolio and Cash Flow
    Due to time lags or other reasons in capital reallocation,  investors often cannot invest in certain markets immediately. Investors can first buy related index futures to lock the bid price and hedge against market price increase which leads to the rise in investment costs.
  5. Hedging Risk 
    If you have a bearish outlook in the market but cannot immediately sell your portfolio for cash due to liquidity problems, you can first sell index futures contracts to hedge against the impact of market value reduction of your investment portfolio.
  6. Arbitrage Trading Opportunities
    The pricing of futures are determinant of various factors and has correlation with the spot market price. If the spot price of individual markets deviates from the theoretical value, investors can adopt the "buy low, sell high" strategy and benefit from the price difference. Besides trading across different markets, arbitrage is also possible within the same market by trading contracts with different maturities.