What are equity futures and how do they work?

An equity futures contract is a type of derivative whereby parties involved must transact shares of a specific company at a predetermined future date and price. The price of the contract is namely determined by the spot price of the underlying stock. In contrast to options contracts, both the buyer and the seller by definition enter into an obligation. At the time of expiration, the buyer is obligated to purchase the underlying shares and the seller is obligated to provide the underlying shares.

Equity futures allow investors to speculate on the future price of a specific stock. In the futures market, buyers and sellers have opposing beliefs about how the value of the underlying will realise. A buyer of an equity futures contract will make a gross profit in the event that the value of the underlying has increased at the futures’ expiration and a gross loss if it decreased. On the other hand, a seller will make a gross profit when the value of the underlying decreases at the expiration and a gross loss if it has increased.

How do equity futures work?

In contrast to other products such as stocks, you do not pay the full cash amount upfront or own the underlying asset. Instead, you have to deposit initial margin to enter into the equity futures position. The amount of margin required is a percentage of the contract value. To find the value of an equity futures contract (notional value), you multiply the price of the underlying stock and the contract size. The contract size is the deliverable number of underlying shares represented in each contract. One contract often has 100 shares of the underlying stock.

If you are unsure of the contract size, underlying and maturity date, you can check the exchange’s website for the contract’s specifications. In most cases, this information is readily available there. Other information regarding the characteristics and risks of the product can be found in its Key Information Document (KID). Moreover, at ESKIMO, you can find the risk category of an equity futures contract behind the name of the product.

Since only a percentage of the contract’s value needs to be put up initially, equity futures are highly leveraged instruments. This means that slight price movements can have a large impact. When the margin requirement is higher, an investor typically needs to deposit more margin to enter the future position. This, in turn, results in lower leverage.

Futures contracts have a minimum price increment to which a particular contract can fluctuate, known as the tick size. This is determined in the specifications of the contract set by the exchange. Tick value, on the other hand, is the actual monetary amount that is gained or lost per contract per tick move and is equal to the tick size multiplied by the contract size.

How and when are equity futures settled?

A unique feature of futures is that they are settled daily. At the end of each trading day, the closing market price is determined by the exchange that the future trades on. This is known as the daily mark-to-market (MTM) price and it is the same for everyone. There are daily mark-to-market settlements until the expiry of the contract or the position is closed out.

The daily cash settlement is the difference between the close price of t-1 and t. Depending on the result, the contract holder’s account is either debited or credited. For example, if at the daily settlement there is an increase in the contract’s value, this will result in a credit to the long position holder’s account and a debit to the short position holder’s account.

At the expiration of an equity future, there is one last daily settlement and then the position is booked out of an investor’s portfolio. It is either cash settled or physically settled depending on the contract. With physical settlement, the underlying shares are delivered to the receiving party. With cash settlement, the credit or debit received is calculated by taking the difference between the spot rate of the equity at expiration minus the futures price.

If you wanted to exit your position before the maturity date, you can by entering into an opposing position. For example, if you were in a long position, you could close the position by entering a short position with the same underlying and maturity.

Investing in equity futures with ESKIMO

What are the risks and rewards?

Trading on a futures exchange can result in high reward, but it also comes with substantial risk of losses. It is possible to lose more than the amount that was invested. If you enter a long position in an equity future, the maximum profit that you can receive is unlimited. This is because, theoretically, the underlying can increase without limits. In this case, if you are in a short position, potential losses are unlimited for the same reason. It is recommended to only enter into obligations that you can meet with money that you do not need in the short term.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.