Newbie Question: How do futures work?

[jls483]

Could anybody point me to a website that will give me a short overview of how a future works (I've had a quick look myself on IB and LIFFE, but they seem to already assume you know it all). Or if my description is almost correct could you just let me know what I have missed out. Thanks,

1. From what I can see you need to find a futures broker, e.g. IB. The broker makes money by charging a commission for each trade and perhaps an account charge and their job is to manage the flow of cash to and from my account based on information from the futures exchange e.g. LIFFE.

2. When I buy or sell a future it is done directly through the futures exchange - there is no middle man. For every contract I buy somebody else must sell. I am effectively in agreement with another dealer saying when the price of this share goes up - you pay me and if it goes down I will pay you (or vice versa).

3. The futures exchange will also handle corporate actions such as dividend payments and my account will be reflected to include this.

Finally a few questions

4. How does LIFFE make its money?

5. Is it possible to instruct your broker to automatically take out new contracts to match expiring contracts - if so is it done at a particular time?

6. Is there any mechanism to keep the price of the future related to the underlying price other than market forces? (For example with an ETF there is a primary and a secondary market and if the price of the ETF gets too far from the real price big institutional players can swap a million ETF shares for the appropriate number of shares that make up the index.)

I think that's the lot.

Thanks,

John.

 

[reactor]

1. you are correct.

2. the middle man is IB who charge a commission for the transaction. IB deal directly into the exchange. you're in an agreement with the recipient of your contract, unless you close out your position before the expiry. only 5% of contracts ever end with the delivery of the underlying. you have the option with IB to either settle by cash or delivery when you set up your account. all you need to worry about is what you buy and sell at and your margin requirements.

3. you do not get a dividend. in theory both the futures price and the underlying on the expiry date are the same, even if the underlying has a dividend. in theory the futures price incorporates this along with corporate action if it affects profits.

4. liffe makes it money through companies dealing direct into the exchange as it costs thousands per month to be connected to it. its a price that is tailored to each company. it also provides the data feed for everyone, which although you can't get direct from them, you can get it from the data vendor, which liffe charges the vendor per person using it. for example IB charge £25 for market depth data (level 2) from liffe for its clients, which is the same price as liffe charge IB for each user using its market depth data. IB makes no money as it carrys the cost to you.

5. IB does not have a rollover procedure. you will have to do it manually when it is optimum to do so. some brokers do have a rollover procedure but only once the contract has expired. you will take on huge basis risk if you let the broker do it.

6. arbitrage is what keeps a futures and its underlying in line. the difference between the futures and the underlying gets smaller and smaller as the expiry date gets nearer. the futures price can be above or below the underlying. for each day of a contract the financial institutions know what the difference should be between the futures and the underlying. if the difference is bigger they will engage in arbitrage. usually its automated as arbitrage opportunites only exist for a few seconds.

they don't swap, but instead buy the cheap and sell the dear and lock in a small profit.

 

[Skimbleshanks]

Reactor has given a very expansive answer, so there's not much more to add.

There are two common types of futures - financial futures and commodity futures. Financial futures (such as S&P500, emini S&P known as ES, etc) are cash settled. Commodity futures (such as wheat, pork bellies, cattle, sugar, coffee, etc) are settled by delivery so you just need to make sure you don't end up with 4 trunkers of wheat on your front drive.

Emini S&P, for example, is electronically traded through Globex, so buyers are electronically matched to sellers. My trades take about 1 second to be filled as ES is a particularly liquid market with around 600,000 contracts per day.

Commodity futures tend to be pit traded, and many such as orange juice are rather illiquid (pun intended), so you are likely to get slippage on your fills. Some only have a few hundred contracts traded per day. And most of these are telephone traded, so it also depends on how good your commodities broker is at getting the fills.

There are also metals and currencies (forex), but you haven't stated which futures you are interested in trading.

 

[jls483]

Thanks reactor and skimbleshanks,

I'm looking to trade any future that is highly volatile. Close to long time lows (like the FTSE) is also good. Something that has a clearly defined midpoint or target range e.g. the price of oil and OPEC's target price range is also interesting. Something that is going to osciallate between 0 and 1 once a day would just about be perfect .

 

[reactor]

if you have a large bank roll for the margin, jls483, trading DOW futures will suit your preference for high volatility.

bear in mind also liquidity, as highlighted by skimbleshanks, when you do choose a futures to trade. don't be caught out by volatile commodity futures with low liquidity.

 

[jls483]

Thanks reactor - do you mean the DOW30 future or single stock futures of companies making up the DOW30?

Isn't the NASDAQ100 more volatile then the DOW30?

I know nothing is for certain, but isn't there a general feeling that the US markets have greater potential for more collapse than the UK markets? In otherwords the DOW30 is more likely to suffer a further 20% fall than the FTSE100 is?

I can now see how the lack of dividend should be factored into the price of a future. Its not often mentioned in the spreadbets/futures argument that although you do pay about 5% interest on your spreadbets you are getting something like 4% in dividends (on the FTSE100). When you throw back into the pot the tax free status ... - sorry just thinking aloud - don't want to start another futures/spreadbets thread.

 

[reactor]

the dow jones industrial average (DJIA) futures contract at $10 a point.

you are correct that the nasdaq100 is more volatile than the DJIA. your bank roll will have to be even larger with contracts at $100 a point. you're heading into the liquidity-volatility trap.

if the US collapses, the rest of the world will follow.