Understanding Derivatives Trading: From Futures Contracts to Practical Applications

Futures Contracts: Risk Management Tool or Speculative Instrument?

Although futures contracts have existed for a long time in global markets, in Vietnam, they are still relatively new to the investor community. Since 2018, when the Vietnam Securities Exchange allowed trading of VN30 index futures, this financial instrument has gradually gained wider recognition. However, due to limited understanding of its operating mechanisms and associated risks, the number of participating investors has not yet met expectations.

Origin and Significance of Futures Contracts

Futures contracts originated from the practical needs of traders to stabilize prices of commodities such as crude oil, rice, or agricultural products. The essence of this tool is to help participants mitigate unpredictable price fluctuations.

A typical real-world example of a futures contract: airlines often need to import fuel with prices constantly fluctuating. To protect themselves against sudden price increases, these airlines usually sign futures contracts with suppliers, locking in the current price to better forecast future costs.

Basic Trading Mechanism

Futures trading operates on two main positions:

Long (Buy): You commit to purchasing the asset at the contract’s maturity date at an agreed-upon price.

Short (Sell): You commit to selling the asset at the contract’s maturity date at a predetermined price.

Let’s analyze a specific futures contract example:

• Asset: Brent oil (UKOIL)
• Maturity date: 31/10/2020
• Quantity: 1000 Barrels
• Agreed price: $43/Barrel

If you anticipate oil prices will rise by the end of October, you open a Long position to buy 1000 Barrels at $43. Before maturity, if the actual UKOIL price increases as forecasted, you can close the position early to realize profit. For example, on 20/10/2020, if Brent oil rises to $44, selling the contract would yield $44,000 instead of the initial $43,000 — a profit of $1,000.

Similarly, with a short strategy, if you expect oil prices to fall and on 20/10/2020 the price indeed drops to $42, you buy back the contract at a lower price. Instead of paying $43,000, you only pay $42,000 — earning a profit of $1,000.

Characteristics of Today’s Derivatives Market

Today, futures contracts are no longer limited to commodities trading. With increasing risk management needs from stock investors, this tool has expanded to nearly all asset types: stocks, cryptocurrencies, gold, crude oil, etc.

Standardization: Each futures contract specifies the asset type, quantity, price level, and maturity date, ensuring consistency across the market.

Listing and guarantee: Contracts are officially listed by the Derivatives Stock Exchange, protecting the rights of participants.

Clearing system and margin: To ensure both parties fulfill their obligations, an initial margin is required. Daily profit and loss are calculated based on the difference between market price and transaction price. If losses become too large, investors are required to top up margin, thus controlling liquidity risk.

Leverage: One of the most attractive features is that you only need to deposit a small margin relative to the total contract value. This allows you to control larger assets with less capital, potentially multiplying profits by 4-5 times the actual market movement.

Risks You Need to Know

Double impact of leverage: While leverage can generate high profits when your predictions are correct, it also amplifies losses when wrong. With a ratio of 1:10, a 5% price movement against your forecast can wipe out half of your initial margin.

Daily profit and loss settlement: Your account is updated daily with gains or losses. If a day’s price movement is strongly unfavorable, you will record an immediate loss and may be required to deposit additional margin to maintain your position.

Speculative nature: Futures are derivative tools that do not generate real value but exploit price volatility. High liquidity and easy position opening/closing make them popular among short-term speculators.

Comparing Futures Contracts with CFDs

(Contracts for Difference) (CFDs) are also derivative instruments, combining features of futures and direct trading. Both allow trading on price movements of various assets without owning the underlying.

Choosing the Right Instrument

CFDs are more suitable for risk-tolerant investors with limited capital, who do not intend to own the actual assets.

Futures contracts are a better choice for large investors who genuinely want to exchange assets or hedge long-term price risks officially.

Conclusion

Futures contracts are powerful derivatives tools that can serve both risk management and short-term speculation purposes. However, to use them effectively and safely, investors need to understand their operating mechanisms, especially the risks related to leverage and daily settlements. The choice between futures and other derivatives like CFDs depends on individual goals, capital, and risk tolerance.