What is a future?

Futures are contractual agreements to take delivery of a commodity or index, such as government bonds, gold or the FTSE 100 index, at a specified future date.

What are the risks of trading futures?

There is no way of knowing for sure the direction of the prices of the underlying asset or the price of futures in advance. Therefore, like many investments, futures carry a risk that market prices may go in the opposite direction of the view held. Futures also allow you to trade on leverage; using a small deposit (margin) you can control a much larger position. This can dramatically magnify your profits but also your losses and if not mitigated correctly you can lose more than you initial investment.

How is a Future Priced?

Futures prices are calculated in a structured way. When you look at a futures price you will see two prices:

BID PRICE is the price at which a trader is willing to buy a futures contract

OFFER PRICE is the price at which a trader is willing to sell a futures contract

The futures price should be equal to the cost of financing the purchase of the underlying asset and the cost of holding it until expiry of the futures contract.

For Example equity futures are derived from share prices and indices. So, in this case, the total cost of buying shares and holding them until expiry of the future contract is made up to three main elements:

. The price of the underlying shares
. Any interest income foregone by holding shares rather than cash
. Any dividends paid to the holder of the shares before the expiry of the future

Or as a formula:

Fair equity futures price = today's share price + interest costs - dividends

Futures on equity indices are priced on a cost of carry basis. The fair value of the index futures contract is determined by adjusting the current cash index price by the net cost of carry of the underlying basket of shares replicating the index. Cost of carry reflects the cash flow considerations of a seller of futures over the life of the contract as he holds the underlying basket of shares.

The cost of borrowing for the financing of the index basket is the main factor, but the income generated from holding the underlying basket of shares must also be taken into consideration. The cost of carry can therefore be defined as the difference between the cost of financing the holding of the basket of shares comprising the index and the income earned on these stocks in the form of dividends (dividend yield).