The future direction of the financial markets is murky at best. This has made investment planning troublesome. A financial contract known as a "futures contract" is something that can be used to help manage the risk of a market downturn or to enable an investor to speculate on what they think will happen next.

The Futures contract can be a proxy for what is expected to happen in the markets. Financial reports on CNBC or Bloomberg television will cite whether Futures are opening up, meaning the investors are expecting a rise in the market. Or the Futures are trading lower in expectation of a decline.

First let's take a look at what is a Futures. Other than trading on expectations of future prices, they are very different from the Forwards contracts that we talked about last week. Whereas, Forward contracts are large institution contracts that are customised between parties, Futures contracts are standardised and available to the sophisticated investing public. They are standardised on a number of factors. First, the type of securities or commodities are standardised in Futures contracts, be they stock indexes, bond sectors, or commodities such as gold Futures.

A distinguishing feature of the Futures contract is that the dollar amount of each contract is a small fraction of a Forwards contract. The Futures contracts will also have a set value for each unit that is traded. So, for example, a six-month bond future will always represent a $100,000 face value. One bond Futures would equal $100,000 in the underlying type of bonds.

Each type of Future has a set ratio. For the S & P500 Index each contract covers $300,000 of the index value at a fraction of the cost. For gold the futures contract equates to about $150,000. Another standard in Forward contracts is the maturities. They are set for particular periods for each contract unlike the negotiated length of time for the Forwards. The maturities or contract cycles are quarterly in March, June, September, and December.

The smaller cost of a Futures and that fact that they are exchange-traded makes them more assessable. Another important feature is that Futures never receive the underlying stocks, bonds, or commodities on which the Futures contract is based. The investor will not end up with a shipment of train loads of wheat or barrels of oil if the contract is not closed-out prior to the expiration. Futures contracts at expiration are always valued in terms of money. Also, the Futures contract can be sold prior to the expiration of the contract, because of they are traded on an exchange which provides liquidity.

A significant difference between Futures and Forward contracts is that Futures do not have the counter-party risk that the other party will pay when due. This is because Futures are exchange-traded through a clearing-house that guarantees the contract will be paid by the other party as required. The clearing-house can provide this guarantee because they require a special 'margin' account be established prior to trading in Futures.

The margin account works to mitigate the risk to the clearing-house. It prevents the Futures position from moving too far into a loss position by topping up the account daily if required.

This margin account has to hold an account balance based on the Futures that have been purchased. As the Futures contracts change in value, the account is increased or decreased daily depending upon whether the values have moved with or against the contract that was purchased. Note that Futures can purchased in anticipation of the market going down as well as up.

When the value of the Futures declines, the investor must add funds into the margin account by the end of the day. Failing that, the positions must be closed-out and the investor is subject to the losses. If the values have moved up, there will be a positive cash balance that can be withdrawn, as long as a sufficient margin remains in place for the open Futures held.

Now with the background on Futures contracts, we can discuss how they are used. They are used by investment managers to hedge against an unwanted change in the direction in the markets. A significant beneficial use for Futures is in creating a type of portfolio insurance. By purchasing a ladder of Futures contracts, an investment manager can lock-in a specific value for a portfolio or a portion thereof. However, this hedging is not perfect. Because of the standardised nature of Futures, it might not be possible to buy the correct number or maturity of contract to exactly match the portfolio. However, a selection of Futures can be purchased to help offset the risks.

Futures are also used to create synthetic index funds. Here the investment manager will assemble a selection of Futures to replicate the holdings within an index. They will be easier to trade, cost a fraction of the price of all the holdings in an index, and in many cases more responsive to market changes because of their future orientation. Recently large part of the activity in Futures is by speculators. They take advantage of the lower cost and inherent leverage to try to create greater gains. With high levels of volatility in the market prices, this can be a costly exercise. However, with the requisite training, monitoring, and risk-controls, trading in Futures can be profitable.

Patrice Horner holds an MBA in Finance, a FINRA Series 7 Licence, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any productions. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.