The world of investing is filled with opportunities, but also a fair share of jargon. The term "ASX futures" might seem a bit overwhelming at first, but once you break it down, it’s easier to see how they work. This guide aims to demystify ASX futures and explain how they could fit into your investing toolkit.

What are ASX futures?

ASX futures are financial contracts that allow investors to speculate on or hedge against the future performance of assets traded on the Australian Securities Exchange (ASX) . These assets often include market indices, such as the S&P/ASX 200 index, as well as commodities and interest rates.

Think of ASX futures like locking in the price of a hotel room months in advance. Even though you’re not planning to actually stay there, you’d settle the difference in cash based on whether the room’s price went up or down by the reservation date. It’s about predicting value, not using the asset.

How do ASX futures work?

ASX futures contracts are standardised agreements traded on the ASX’s derivatives market. Each contract outlines:

• The underlying asset (e.g., the S&P/ASX 200 index)
• The contract size (the amount of the underlying asset the contract represents)
• The expiry date (when the contract settles)
• The settlement type (cash settlement is the norm for index futures)

When you buy or sell an ASX futures contract, you’re essentially betting on the direction of the asset’s price by the expiry date. If you think the price will go up, you’ll buy (go long). If you think it will go down, you’ll sell (go short). Profits or losses are based on the difference between your entry price and the closing price.

Trading futures requires something known as a margin account. Think of a margin account as a safety net: it’s a special account where you deposit funds that act as collateral. This ensures you can cover any potential losses from your trades, and it allows your broker to manage the risks involved.

Why would someone use ASX futures?

Investors and traders typically use ASX futures for two main reasons:

1. Speculation : Futures can be a way to profit from market movements without owning the underlying assets. Speculators use futures to leverage their positions, controlling a larger investment with less capital.
2. Hedging : Futures help protect against unfavourable price movements. For example, a portfolio manager might use ASX futures to hedge against a potential stock market decline . Similarly, businesses can lock in prices for raw materials with commodity futures.

ASX futures in action

Here’s a purely hypothetical look at how ASX futures could work.

Imagine you believe the Australian stock market, as measured by the S&P/ASX 200 index, is set to rise. You decide to act on this by buying an S&P/ASX 200 futures contract at 7,000 points. Each point is worth $25, so the total value of the contract is $175,000 ($25 × 7,000).

The good news? You don’t need to pay the full $175,000 upfront. Instead, you deposit an initial margin – a fraction of the contract’s value – into your trading account. For example, if the margin is 5%, you’d only need $8,750 ($175,000 × 5%) to get started. This acts as a security buffer in case the market moves against you.

By the expiry date, if the index rises to 7,200 points, the contract’s value increases by 200 points. That gives you a $5,000 profit (200 points × $25 per point), which gets added to your account. But if the index falls to 6,800 points, the contract’s value drops by 200 points, leaving you with a $5,000 loss. If your account doesn’t have enough to cover the losses, you’ll need to add more funds (a margin call ) to keep the trade going.

How could futures be useful?

ASX futures offer a range of potential benefits, but their utility depends on your investing strategy and goals. Here are some key ways they can be valuable:

1. Diversification : Futures let you gain exposure to an entire market index, like the S&P/ASX 200, without needing to purchase individual stocks. This can simplify portfolio diversification
2. Cost efficiency : With futures, you can control a large position using less initial capital compared to directly buying the underlying assets. This can make them a cost-effective tool for investors with limited funds
3. Flexibility : Whether markets are rising or falling, futures allow you to profit by choosing to go long (betting the price will rise) or short (betting the price will fall)
4. Risk management through hedging : Futures can act as a potential safeguard for your portfolio. For example, selling ASX futures may be able to offset potential losses during a market downturn, providing a possible layer of protection for your investments

What are the risks of ASX futures?

For first-time investors , the complexity of ASX futures is the most important risk to understand. Futures aren’t like typical investments; they require knowledge of contract details, market mechanics, and leverage. Here are the key risks:

1. Complexity: Navigating futures without understanding how trades and pricing work can lead to costly mistakes. This makes education essential before diving in
2. Leverage risk: While leverage can amplify profits, it can also magnify losses, sometimes exceeding your initial deposit
3. Market volatility: Rapid price changes from market events can lead to unexpected losses
4. Margin calls: If the market moves against your position, you may need to add funds to your margin account or risk losing your position
5. Liquidity risk: Low trading volume on some contracts can make it difficult to buy or sell without affecting prices

Wrapping it up

ASX futures can be a solid tool for investors seeking opportunities to speculate, diversify, or manage risk. However, they’re not without significant risks, especially for beginners. If you’re considering futures trading, take the time to understand how they work, evaluate whether they align with your financial goals, and assess your comfort level with potential downsides (AKA your risk tolerance ).

As always, remember to do your own research and seek advice from a licensed financial adviser before making any investment decisions. Futures trading isn’t suitable for everyone, and professional guidance can help determine if it’s the right choice for you.

Happy investing!