Futures contracts are an advanced trading tool in the box of both TradFi (traditional finance) and crypto investors. We explained the basic workings on a futures contract in part one of this series, while in this article we will go into the different strategies of investing in futures.
Hedging in Futures Contracts
There are two fundamental hedging strategies using futures contracts, namely, short hedge and long hedge.
What is a Short Hedge?
A short hedge is a hedging strategy that involves a short position in futures contracts. It can help mitigate the risk of a declining asset price in the future. Investors and firms usually use this strategy for the assets they sell.
Here is an overview of a short hedge:
On Jan 15, an oil producer enacts a contract to sell 1 million barrels of crude oil and the sale price is the market price on Jul 15. The oil producer will gain $1 million for a rise of $1 in the oil price over the next six months and lose $1 million for a drop of $1 in the price during this period.
Meanwhile, the crude oil futures price for July delivery is $100 per barrel. As hedge ratio equals value at risk divided by notional value, it equals ($100 × 1 million/ ($100 per barrel times 1,000 contracts) = 1,000 contracts. The company can effectively hedge its market exposure by shorting 1,000 futures contracts. If the oil producer closes out its position on July 15, the intended effect is to lock in a price close to $100 per barrel and hence $100 million in total.
Case 1: Suppose that the spot price on July 15 turns out to be $102 per barrel. The company realizes $102 million (= $102 x 1 million) for the oil under its sales contract. The price of the futures contract should be very close to the spot price of $102 on the expiry date, and for simplicity, we now assume they are exactly the same. The company therefore loses $102 – $100 = $2 per futures contract and $2 million on the futures position in total. As a whole, the company realizes a revenue of $(102 – 2) million = $100 million.
Case 2: Alternatively, the spot price on July 15 turns out to be $96 per barrel. The company realizes $96 million for the oil under its sales contract. It gains $100 – $96 = $4 per futures contract and $4 million on the futures position in total. Again, the company realizes a revenue of $(96 + 4) million = $100 million.
We can thus see that the short hedge helps locking in the revenue at $100 million with futures regardless of the price changes.
What is a Long Hedge
A long hedge is a hedging strategy that involves a long position in futures contracts. It can help mitigate the risk of a rising asset price in the future. Investors and firms usually use this strategy for the assets they plan to buy.
Here is an overview of a long hedge:
Assuming on Jan 15, a manufacturer knows that it needs to have 100 thousand tons of steel on Jul 15. On Jan 15, the spot price of steel is $630 per ton, and the futures price for July delivery is $600 per ton. The manufacturer can hedge its position by taking a long position in futures contracts and closing its position on July 15. Each contract is for the delivery of 100 tons of copper. The intended effect is to lock in the price of the steel at $600 per ton and $60 million in total.
Case 1: The purchase cost turns out to be $660 per ton. The futures price converges to the spot price on the expiry date, and here we assume they are the same on the expiry date. The manufacturer then gains $(660 – 600) × 100,000 = $6 million on the futures position. The purchase cost of the steel is $660 × 100,000 = $66 million. Thus, the net cost equals $(66 – 6) million = $60 million.
Case 2: The purchase cost turns out to be $520 per ton. The manufacturer then loses $(600 – 520) × 100,000 = $8 million on the futures position. The purchase cost of the steel is $520 × 100,000 = 52 million. Thus, the net cost equals $(52 + 8) million = $60 million.
In both examples, for simplicity, we have assumed that there is no daily settlement. With daily settlement, the payoff from the futures contract is realized day by day throughout its life. It can slightly impact the performance of a hedge in practice.
Basis risk
The above examples are all perfect hedges eliminating uncertainty in the future prices, but in practice hedging also involves an inherent risk known as basis risk. It refers to the difference between the spot price of the asset to be hedged and the price of the futures contract used.
If the asset to be hedged and the asset underlying the futures contract are equivalent, the basis equals zero at the expiration of the futures contract. Prior to expiration, the basis can be positive or negative. An increase in the basis is known as a strengthening of the basis, while a decrease in the basis is known as a weakening of the basis. Changes in basis can improve or worsen a hedger’s position.
In the case of a short hedge, the hedger’s position improves with an unexpected strengthening of the basis because the hedger will earn a higher price for the asset after considering gains or losses from the futures. Following the same rationale, the hedger’s position worsens with an unexpected weakening of the basis.
In the case of a long hedge, the opposite holds. An unexpected strengthening of the basis worsens the hedger’s position, since the hedger needs to pay a higher price for the asset after considering gains or losses from the futures. If the basis weakens unexpectedly, the hedger’s position improves.
Basis risk generally increases with the time difference between the hedge expiration and the delivery month. A practical rule of thumb to mitigate basis risk is to pick a delivery month that is as close as possible to, but later than, the expiration of the hedge. Assume the delivery months are March, June, and September for a futures contract on a particular asset. For hedge expirations in December, January, and February, the March contract is the best choice for mitigating basis risk
Futures vs Options
Both futures and options are common derivatives used in trading, but they have different properties. Here we go over some of their prominent differences. You can also read our articles on option basics and option strategies for a deeper understanding about their uses and trading strategies.
Rights or obligations
Futures are legal binding contracts that require both buyers and sellers to respectively purchase and deliver the underlying assets according to the terms. As for options, the buyer has the right to buy (call option) or sell (put option) the underlying asset, and it is not a must for the buyer to exercise the right. The option seller must act according to the buyer’s decision.
Potential gain and loss
For both buying and selling a futures contract, the potential gain or loss is theoretically unlimited. On the other hand, the payoff structure of options is ‘asymmetrical’. For buyers, the potential gain is unlimited while the maximum loss is limited to the premium paid. For sellers, the maximum gain is limited to the premium received while the potential loss is unlimited.
Premium cost and margin requirement
When opening a futures position, you need to pay a margin deposit irrespective of whether you buy or sell a contract. For options, the buyer pays the premium when the contract starts, and does not have to post a margin. Only the option seller must pay a margin.
Perpetual Contracts
Perpetual contracts are derivative contracts similar to traditional futures, except that they have no expiry or settlement date. They are particularly popular in the cryptocurrency space as they allow traders to hold leveraged positions without the burden of an expiration date.
Compared to traditional futures, perpetual contracts also trade closer to the index price of the underlying asset thanks to its ‘funding rates’ mechanism.
The index price is the average spot price of the underlying asset across multiple exchanges. A funding rate is the sum of two main parts: the interest rate and the premium. The interest rate component is usually constant, and it depends on the interest rates for borrowing of the assets specified in the contract. The premium component is the difference between the perpetual price and the mark price, which is derived from the index price.
If the funding rate is positive, longs pay shorts. If it is negative, shorts pay longs. The total amount of funding involved is calculated as follows:
Funding = Position Value × Funding Rate
Funding rates motivate traders to buy perpetual contracts when the contract price is lower than the index price and sell when the contract price is higher than the index. As a result, the price of the contract closely tracks the underlying asset price.
You should be aware of the tick value of the futures contract you are trading and the usual tick movements of the contract. They would significantly impact the profit and loss and the corresponding volatility of your futures position.
Crypto Futures & Other Advanced Trading
Now you have learnt the basics of trading future contracts. Also check out our various articles on options and the basics of an exchange to up your advanced trading knowledge.
References
1. CME Group. (2020). Introduction to Futures. Retrieved from CME Institute: https://www.cmegroup.com/education/courses/introduction-to-futures.html
2. Hull, J. C. (2018). Options, Futures, and Other Derivatives . Harlow: Pearson Education Limited.
3. The Investor and Financial Education Council. (2020). Futures and options. Retrieved from The Investor and Financial Education Council: https://www.ifec.org.hk/web/en/investment/investment-products/futures-and-options/index.page
4. DeFi Rate (2020). Perpetual Contracts Overview Guide: Definitions & FAQ. Retrieved from DeFi Rate: https://defirate.com/perpetual-contracts/#:~:text=A%20perpetual%20contract%20is%20a,an%20indefinite%20amount%20of%20time.
