Understanding Futures Trading: Essential Insights and Facts
Futures trading is a method to anticipate or safeguard against the future worth of assorted assets, including shares, bonds, and commodities. Engaging in futures trading can offer significantly more leverage than stock trading, opening up the likelihood of substantial gains yet bearing substantial risks.
If you grasp the inner workings of futures markets and recognize their potential role in your investment strategy, they can offer a refreshing dose of diversification to your assets.
What are futures?
What are futures?
When someone mentions "futures" within the financial realm, they usually mean futures contracts. A futures contract outlines the terms for the delivery or cash settlement of a particular asset, such as shares, raw materials, or goods, at a predetermined future date. The contract's value mirrors the value of the underlying asset, making futures a type of derivative financial instrument.
Unlike option contracts, futures contracts require the contract holder to fulfill the contract's conditions. That's the main distinction between futures and options contracts. With options, the contract holder has the choice to fulfill the contract, but is not obligated to do so.
Futures contracts are particularly beneficial to businesses. For instance, if you own a farm that produces corn, you might want to secure a price for your corn ahead of the harvesting season. This guarantees a specific income for the year and shields you from potential price drops. On the other hand, it means you'll miss out on any potential gains if the price of corn skyrockets before the harvesting season.
You can trade both buy and sell futures contracts. If you buy a contract, you agree to pay a particular price at a specified date. If you sell a contract, you commit to delivering the underlying asset at the predetermined price.
Understanding futures
Understanding futures
Futures contracts are typically exchanged on a stock exchange, which sets the guidelines for each contract. Since the contracts are standardized, they can be easily traded between investors. This ensures sufficient liquidity, preventing speculators from being stuck with physical delivery of large quantities of oil, for example.
Each contract is for a standard volume of the underlying asset. For example, gold futures trade in contracts for 100 troy ounces. At a gold price of around $2,000 per ounce, each futures contract is worth $200,000. Oil is measured in barrels, which equate to approximately 42 gallons, and each futures contract is for 100 barrels. Corn is measured in bushels, which weigh approximately 56 pounds, and futures contracts are standardized to 5,000 bushels.
Futures contracts stipulate the settlement method between the two contract parties upon contract expiration. Will the contract holder receive physical delivery of the underlying asset, or will they receive a cash settlement for the difference between the contracted price and the market price at the time of expiration?
With standardized futures contracts, investors can easily speculate on the future value of any asset traded on the futures market. If speculators believe the price of oil will surge in the coming months, they can buy a futures contract for a few months from the current date. As the expiration date approaches, they can sell the contract, hopefully realizing a profit.
Some parties employ futures contracts to hedge their positions. A producer can use futures contracts to lock in a price for their products. For example, an oil company may want to secure a specific price for their output for the year and sell oil futures to interested investors.
On the other hand, a company may hedge against commodity price fluctuations. For example, an airline might buy futures for jet fuel. This provides predictable expenses, even if the price of jet fuel fluctuates.
Another way to hedge using futures is if you own a diverse portfolio of stocks and wish to protect yourself against downside risk. You could sell a futures contract for a stock index. The position would increase in value if the stock market decreased.
Pros and cons
Pros and cons of trading futures
Pros
- Easy to bet against the underlying asset. Selling a futures contract can be simpler than short-selling shares, and you'll gain access to a broader range of assets.
- Simplified pricing. Futures prices are determined by the current spot price and adjusted for the risk-free rate of return until expiration and the cost of storing commodities that will be physically delivered to the buyer.
- Liquidity. Futures markets are highly liquid, making it simple for investors to enter and exit positions with minimal transaction costs.
- Leverage. Futures trading can offer greater leverage than a conventional stock brokerage account. You might only obtain 2:1 leverage from a stockbroker, but with futures, you could secure 20:1 leverage. However, with greater leverage comes greater risk.
- An easy way to hedge positions. A strategic futures position can safeguard your business or investment portfolio against downside risk.
Cons
- Vulnerability to price fluctuations. If your position goes against you, you may need to add more funds to cover the maintenance margin and prevent your broker from closing your position. And when you use a lot of leverage, minimal movement in the underlying asset can force you to provide additional funds. This can potentially turn a potential big winner into a mediocre trade at best.
- Lack of control over the future. Futures traders also face the risk that the future isn't predictable. For instance, if you're a farmer planning to sell corn in the fall, but a natural disaster destroys your crop, you'll need to buy an offsetting contract. And if a natural disaster destroyed your crop, it's likely not the only one, and the price of corn may have significantly increased, resulting in significant losses along with the fact that you won't have any corn to sell. Similarly, speculators are unable to foresee all potential impacts on supply and demand.
- Expiration. Futures contracts have an expiration date. Even if you were correct in your speculative call that gold prices will increase, you could end up with a bad trade if the contract expires before that point.
How to trade futures
Trading Futures 101
To get started with futures trading, you'll need to open a new account with a broker that supports the markets you want to trade. Many online stock brokers also offer futures trading.
To gain access to futures markets, they may ask more detailed questions than when you opened a standard stock brokerage account. These questions might include how much capital you need to start futures trading, details about your experience, income, and net worth, all designed to help the broker determine the amount of leverage they're willing to offer. Futures contracts can be bought with significant leverage if the broker deems it appropriate.
Fees differ from broker to broker for buying and selling futures. Make sure to shop around to find the broker that fits your needs best in terms of price and services.
Once your account is set up, you can choose the futures contract you'd like to buy or sell. For example, if you want to bet on the price of gold climbing by the end of the year, you could buy the December gold futures contract.
Your broker will determine your initial margin for the contract, which is usually a percentage of the contracted value that you need to provide in cash. For example, if the value of the contract is $180,000 and the initial margin is 10%, you'll need to provide $18,000 in cash.
At the end of every trading day, your position is marked to market. This means the broker determines the value of the position and adds or deducts that amount in cash to your account. If the $180,000 contract fell to $179,000, you'd see $1,000 deducted from your account.
If the equity in your position falls below the broker's margin requirements, you'll be required to bring more cash to the account to meet the maintenance margin.
To avoid taking physical delivery of the underlying asset, you will likely need to close your position before expiration. Some brokers have mechanisms in place to do this automatically if you wish to hold your position right up until it expires.
After making your first futures trade, you can repeat the process, hopefully with great success.
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Are futures the right fit for you?
Futures offer limited benefit to the majority of individual investors. The benefit is the ability to use more leverage with futures contracts, but leverage is a two-edged sword. Gains are magnified, but so are losses.
Futures can be useful, however, to invest in assets outside of standard stocks, bonds, and real estate investment trusts (REITs). Instead of buying an energy stock, for example, you can buy a futures contract for oil.
Alternatively, you can invest in an exchange-traded fund (ETF) that tracks the commodity's value. While you may incur an expense ratio on the fund, it'll save you from having to manage a futures position or meet the requirements for a futures trading account.
While futures are a useful tool for businesses and advanced investors, most individual investors are better off with a simple buy-and-hold strategy that doesn't require a margin account. Our website has a disclosure policy.
Utilizing futures contracts can provide an alternative investment avenue for diverse assets, beyond traditional stocks and bonds. For instance, an investor interested in the oil market may opt for an oil futures contract, instead of investing in an energy stock.
When exploring various investment options, it's crucial to consider your investment strategy and risk tolerance. For many individual investors, a straightforward buy-and-hold approach might be more suitable, avoiding the need for a margin account that's required for futures trading.
