Futures: An Added Dimension To Trading Oil And Gas Stocks
Authors: Clademenos Andrew 
Published: March 2010

Introduction

For many people, "commodity" and "futures" conjure up visions of wildeyed speculators gambling on the price of pork bellies or soybeans. However, the most widely traded futures contracts are those based on government bonds and stock market indices. Such contracts in recent years, have provided an added dimension to trading strategies to manage interest rate and stock market risk. This paper briefly describes futures markets generally, and the Oil and Gas Index futures contract traded on The Toronto Futures Exchange in particular. The Oil and Gas Index futures began trading on February 6, 1985 and is the nly sub-index futures contract in the world.

What is a Futures Contract?

A futures contract is a contract to buy (take delivery) or to sell (make delivery) of something at a future date (delivery month). That something is commonly referred to as the underlying commodity. The word commodity may include anything from pork bellies and wheat to treasury bills and the Japanese yen.

The Toronto Futures Exchange

The first organized futures market in Canada can be traced back to the late 1800s in Manitoba (grain and produce). Now there is The Toronto Futures Exchange which officially opened on January 16. 1984. It is the home of interest rate futures, stock index futures and currency futures as well as options on silver bullion.

Hedgers and Speculators

There are two participants in the futures market: hedgers and speculators. Generally, hedgers are individuals or corporations who deal in the underlying commodities and buy or sell futures contracts to minimize the risk they are exposed to in daily business.

Speculators, on the other hand, assume the risk, hedgers wish to avoid. They speculate in the market purely to make a profit.

Delivery

Stock index futures (contracts based on the Toronto Stock Exchange 300 Composite Index and the Oil and Gas Index) are different from traditional contracts calling for actual delivery. TSE 300 futures and Oil and Gas Index futures are settled in cash because delivery of the underlying commodity, 300 stocks or 60 stocks respectively, would be unmanageable.

Futures contracts which call for physical delivery are infrequent. Normally less than five per cent of all positions become involved in this process.

Most often, an open position is closed out or liquidated before delivery time rolls around. This is done by entering into what is called an offsetting transaction equal and opposite to what was done initially. For example, if one bought three bond futures, one closes out one's position by selling three bond futures.

Margin

The key to the attractiveness of futures contracts is the low margin required (usually 5 – 10%) to maintain a position in the market. This provides tremendous leverage and can result in very large and lightning quick gains or losses. Margin in the commodity futures market is not a down payment as in the stock market. Essentially, futures margin acts as a good faith deposit or performance bond. Every buyer and seller of a futures contract must make a margin deposit with a broker before opening a position to ensure the performance ofthat contract.