futures trading discount is a popular type of financial market instrument, and for a good reason. Futures contracts allow traders to lock prices for a specific asset and receive or deliver it on a future date at that locked-in price. As a result, futures trading helps establish price discovery for asset classes such as commodities, currencies, and financial instruments. However, trading futures contracts can be quite risky, especially when market conditions change. Luckily, traders can hedge their futures positions by utilizing discounted futures contracts. To help you understand discounted futures better, we have created this comprehensive guide.
What are discounted futures?
Discounted futures, also known as serial futures, are futures contracts that have a delivery month that follows the near month. Essentially, discounted futures are futures contracts of the same underlying asset type and contract specifications as the near month future but have a later delivery date. Moreover, the discounted futures contracts have lower prices than the near month’s futures contracts because of the time value of money. In other words, the further away from the current month, the fewer market participants are willing to pay for a futures contract due to the uncertainty of market prices in the future.
Why trade discounted futures?
The primary reason to trade discounted futures is to hedge existing futures positions. Traders will manage their futures positions based on market expectations, but sometimes, market price changes can exceed those expectations, leading to significant losses. In such cases, traders can use discounted futures contracts to hedge their position. The hedging can either be a long or short position on the discounted contract. Hedging a long position on the near futures contract with a short position on the discounted contract or vice versa can help to reduce the risk of loss.
How are discounted futures priced?
Discounted futures prices are determined based on the expected market volatility over the contract’s delivery period. The pricing model calculates the cost of carry or the interest rate that traders would have to pay to hold the asset. The cost of carry consists of the short-term interest rate of the underlying asset’s country, storage cost of the underlying asset, and insurance costs for holding the asset. The farther the delivery date from the near month’s futures contact, the higher the cost of carry, which leads to lower prices for the discounted futures.
Margin requirements for discounted futures.
Margin requirements are the amount of money traders need to hold in their accounts to cover potential losses in their positions. The margin requirements for discounted futures are similar to those for near month futures. They can vary depending on the type of underlying asset, the exchange where the futures trade, and whether traders are long or short. Generally, the margin requirements for discounted futures are lower than the near month futures since they are less volatile.
Risks and Disadvantages of trading discounted futures.
Like trading near month futures, trading discounted futures carries its own set of risks. Firstly, changes to the underlying assets’ supply and demand can result in changes in market prices, which would affect the discount and near months’ futures prices. Additionally, traders who utilize discounted futures for hedging may not get the full hedge due to delivery costs, commissions, and slippage, which are standard costs in futures trading. Traders should also be careful when rolling over futures positions between months. Rollover costs may reduce the net profits made from the strategy. As always, traders should manage their positions accordingly.
Discounted futures contracts are a useful tool for traders in risk management and hedging strategies. The contracts provide traders with an avenue to hedge their futures positions and reduce their risk exposure. However, traders should always exercise caution when trading discounted futures, understanding the pricing mechanisms, carry costs, and associated risks. With the tips discussed in this article, traders can take advantage of discounted futures contracts and make more informed trading decisions. Remember, always manage your risks, and happy trading!