Why did futures markets develop?
The raison d'etre of futures markets lies in the rapid expansion of world trade from the nineteenth century onwards and the increasing demand for raw materials, most of which were sourced from abroad, from manufacturers and processors. The geographical areas of trade and the time consuming means of transport resulted in lengthy delays between production and eventual sale. The result was that the manufacturers and producers were obliged to hold ever increasing stock levels. This was an inefficient use of the capital employed, whether borrowed or otherwise, and any change in the price of the raw material could have a serious and adverse effect. To overcome these risks, traders and manufacturers sought a means of constraining the uncertainties by bringing together the shippers, producers and processors under one roof where they met to agree quantities, prices and payment terms so affording a hedge against financial and commercial risk. Whilst futures markets were originally conceived to give protection, financiers and investors quickly recognised the opportunities for speculative gains in rising and falling markets.

What is a futures contract?
A futures contract is a standardised contract to buy or sell a specified asset at a pre-agreed price on a pre-agreed date. It is akin to a cash transaction with the final element - settlement - being deferred.

Nowadays most futures contracts are transacted on a recognised exchange using a broker, with the quality and quantity of the underlying asset standardised. Additionally, the exchange specifies the dates (or range of dates) within which deals must be settled, so assisting trading and ensuring liquidity. Futures contracts that are not exchange traded are known as 'over the counter' or 'OTC' products.

What markets have futures contracts?
Futures contracts fall into two distinct categories - commodities and financials. As a new commodity is rare, the growth in the variety of futures contracts has been in the financial category.

Commodities comprise precious metals (e.g. gold, silver, platinum) and base metals (e.g. copper, zinc, lead and aluminium), 'softs' (e.g. coffee, cocoa and sugar), other agricultural products (e.g. grains, cattle) and energy commodities (e.g. crude oil, gas oil and heating oil). Financial futures contracts include currencies, bonds, short-term interest rates, stock indices and equity futures.

What information is available about these markets?
Most of the quality newspapers contain comment and other information about the world's financial markets and the prices of numerous futures and options contracts. The Financial Times and Wall Street Journal are excellent sources of such data.

Conversely, data regarding the commodity markets is rather harder to come by. Generally, the factors affecting commodity price movements derive from the regions where the producers or suppliers are located. Such factors may include adverse climatic conditions (e.g. frosts affecting Brazilian coffee growing regions), labour disputes or armed conflicts. The timely supply of this information and the interpretation of its effects on prices are dependent on those closely connected with the relevant markets. Sucden has over 30 years experience and expertise, notably of the commodity markets, and is, therefore, well placed to provide pertinent information.

What is initial margin and how does it work?
Margin is the cash (or other acceptable security) lodged and maintained with your broker as the cost of opening a contract in the futures market. Initial margin is a demonstration of good faith. When a position is closed out the initial margin will be returned. Without fail, both the buyer and the seller of a contract must lodge margin with their broker through whom it may then be deposited with the exchange or official clearing house.

Market prices fluctuate each day and the value of each day's gain (or loss) is known as the variation margin. In the event that the market price has moved against your position you will be 'margin called' to the extent of the negative variation margin. Any margin call must be met in full on the day of calling. In a similar vein any positive variation margin is credited to your account.

How much margin do I have to pay?
Initial margin requirements are determined having regard to contract size and historical volatility. They normally range between 3% and 20% of the total contract value. The margin requirement for an exchange-traded contract is established by the relevant exchange and can vary, without prior notice, should the exchange deem it necessary in order to protect investors or prevent price distortions. Sucden will be happy to advise on the margin requirements for a particular contract.

How risky is investing in futures markets?
The futures markets are perceived as being toward the riskier end of the investment scale. This is attributable more to the potentially highly geared nature of transactions rather than because the markets are more volatile than more conventional investments.

What is gearing and how does it increase the risk profile?
As a futures contract is an agreement to buy or sell an asset at some pre-determined date it would defeat the object of the contract if payment or settlement was to be made or received in advance of the agreed date. Consequently futures markets require the payment of initial margin (see above) when opening a contract. As the margin requirement is normally a small fraction of the total value of the contract, a high degree of gearing will exist.

For example, if the initial margin equates to 5% of the contract value then the gearing is a factor of 20. It is this gearing that can lead to spectacular profits in relation to the initial margin deposit, but by the same token, the potential for loss is equally large. The following examples demonstrate comparable cash market and futures market trades. In each case the investor has formed the opinion that the price of gold will increase in the short term.

Futures Trade
On 15 October Buy 1 (one) lot December COMEX (the Exchange) Gold @ $280 per Troy oz.

1 lot is 100 Troy oz.

The initial speculative margin for 1 lot is $1,350

On 23 November Sell 1 lot December COMEX Gold @ $290 per Troy oz.

The profit generated on this transaction is: $290 less $280 x100 oz. = $1000

As a consequence the return on the original investment (the initial margin is: $1000/$1350 x 100 = 74%

Cash Trade
On 15 October Buy 100 Troy oz. Gold @ $280 = 100 x $280 = $28000

On 23 November Sell 100 Troy oz. Gold @ $290 = 100 x $290 = $29000

The profit generated on this transaction is: $29000 - $28000 = $1000

In this instance the return on the original investment is: $1000/$28000 x 100 = 3.57%

Whilst the profit ($1000) is the same in each example the futures trade produced a return of 74% on the original investment ($1350) compared with just 3.57% for the cash trade where the original investment was $28000. In the event that the investor's opinion was misplaced and the price of gold dropped by $10 to $270, the loss in each case would have remained constant at $1000 but the loss from the futures trade, as a percentage of the original investment, would have been 74%.

Do I have to hold a futures contract through to its maturity?
As you will have seen in the example above the December futures contract was sold on 23 November - well before its maturity date. Typically, futures contracts are held for less than their full term. Until the delivery date they can be opened and closed out as frequently as required. If a futures contract is held towards the end of its term there comes a time (between one day and one month depending on the commodity or instrument) from the contract expiry date when the holder of the contract could become liable to deliver or take delivery of the underlying asset. It is uncommon for a private investor to hold futures contracts during such periods and Sucden would normally advise against putting yourself in such a position.

Having opened a futures contract how do I close the trade?
There are two choices. You could meet the requirement to make or take delivery of the underlying asset or, the more likely choice, is to instruct the broker through whom you opened the position to enter into an equal and opposite trade. The example above illustrates a closing out of an open position.

Is there a way in which I can limit the risk?
Some futures contracts give rise to a potential unlimited liability and in recognition of this the market operates a system of stop-limit orders. Such limits can form an integral part of the instruction to your broker. Limits can be placed both to seek to constrain a loss should the market move against you or to take a profit once a pre-determined improvement in the price is achieved. We advise inexperienced clients to place a stop-limit whenever they enter into a trade. This will liquidate that position, at a pre-determined price, should the market move adversely. Stop-limits are not guaranteed, but we are committed to securing the best possible price for you in the prevailing circumstances. For widely traded futures contracts the market liquidity is such that it is normally possible to prevent significant runs through a stop-limit.

The risk of investing in futures can also be limited by investing in traded options.

What are traded options?
An option contract gives the purchaser of the contract the right - but not the obligation - to buy (call option) or sell (put option) a futures contract at a fixed price at any time on or before a predetermined date (American style option) or on a pre-determined date (European style option). The premium paid to purchase the option is the total extent of the risk incurred by the purchaser. The seller (or writer) of the contract takes on the risk that the purchaser was unwilling to assume. That liability can be unlimited and, accordingly, we do not recommend that inexperienced investors write traded options.

What costs will I incur in trading in these markets?
In addition to meeting (and maintaining) the initial margin for a futures position or paying the premium when buying an option contract your broker will charge a commission. These are negotiated and agreed on an individual basis and will be discussed with you as part of the account opening process. Commission is charged either on a 'per side' basis or for the 'round turn'. The former means that a commission is charged on entering into the transaction and again on closing out. The total charge will equate to the round turn change.

How do I go about opening an account with Sucden?
Just complete the enquiry form by clicking here and we will contact you with further details.