Futures Trading: Everything You Need to Know
Futures trading is a way to hypothesise or hedge against the future value of various assets. These assets can be stocks, bonds or commodities. Trading futures is highly desirable as it provides greater leverage than trading stocks. Trading futures offer traders the potential to achieve very high capital returns. One of the downfalls of futures trading is there are very large risks involved.
If a trader has an understanding of futures trading, it can lead them to diversify their holdings. It is important for traders to develop an understanding of how future markets work and how futures can benefit their portfolios.
What are futures?
Typically when the word “futures” is used in the financial world it really means futures contracts. Futures contracts provide terms for the delivery or cash settlement of a specific asset. These assets could be stocks, raw materials or products at a specified future date. The value of the contract is based on the value of the underlying asset. This means that futures are a form of derivatives.
The key difference between futures and stock options is that futures require the contract holder to settle the contract. Stock options give contract holders the right to settle contracts but do not oblige them to do so.
Futures can be particularly beneficial for businesses. For example, if you are a farm owner who grows corn, you may want to set a price for your corn prior to harvest time. This way a set amount of income can be guaranteed and there will be no losses if the price of corn drops.
There is one downfall to this, if the price of corn skyrockets before that harvest, the business will not be able to benefit from this price increase.
Futures contracts could be sold or bought. If you buy a contract, you agree to a certain price on a specific date. If you sell a contract, you agree to provide the underlying asset at a set price.
Futures contracts are usually traded on the stock exchange. This sets the standards for each contract. Contracts are standardised, meaning they can be exchanged freely between investors providing the necessary liquidity. Guaranteeing that speculators don’t end up taking physical delivery of a tanker-load of oil.
Each contract is based on a standard amount of the underlying asset. Let’s take a look at gold futures, they are traded in contracts for 100 troy ounces. Therefore, if gold is trading for $2,000 per ounce, each futures contract is valued at $200,000. If we take a look at oil, it is measured in barrels. Each barrel is about 42 gallons and there are 100 barrels in each futures contract. Corn is measured in bushels. Each bushels weighs about 56 pounds and there is a standardised amount of 5,000 bushels in futures contracts.
Futures contracts also determine how two parties in contract settle on a trade. The futures contract could provide a cash settlement for the difference between the market and the contracted price at the time of expiration. Another option could be that the contract holder can take physical delivery of the underlying asset.
Standardised futures contracts are an easy way for investors to determine the future value of any asset traded on the futures market. A speculator can buy a futures contract for three months or more from the current date if they believe the price of oil might spike. They can easily sell the contract and make capital gains if the contract is close to the exercise date.
Futures contracts are also sometimes used to hedge positions. The cost of goods could be locked in by a producer through futures contracts. For example, an oil company might want to make sure they will receive a specific price on output for the year and might sell oil futures to any interested parties.
Another option could be that a company hedges the market for commodities that they consume. For example, an airline company might purchase futures for jet fuel. This provides them with predictable expenses even if the value of the jet fuel fluctuates.
Investors could hedge using futures if they own a wide range and diversified portfolio of stocks. They could sell a futures contract for a stock index and protect themselves against the downside risk. If the stock market went down the position would increase in value.
How to trade futures
In order to get started in futures trading, investors must open a new account with a broker that supports the specific markets that they want to trade in. Futures trading is offered by many online stockbrokers.
In order for investors to gain access to futures markets, they may be required to answer more in-depth questions than they are typically asked when opening a standard stock brokerage account. These questions could include income, experience and net worth which help the broker determine the amount of leverage they will grant. If the broker considers it fitting, futures contracts could be purchased with very high leverage.
A broker’s fee varies when buying and selling futures. Potential investors should make sure they do their research on prices and services when determining the broker that suits them best.
Once an account is open, users can select the futures contracts they wish to purchase or sell. For example, if you predict that the price of gold will increase significantly by the end of the year, you would purchase a gold futures contract in December.
The broker determines the initial margin for the contract. Typically, the amount of capital you need to provide is based on a percentage of the contracted value. For example, if the contract is valued at $180,000 and the initial margin is 10%, $18,000 is what is required to be paid.
Positions are marked to market at the end of every trading day. Meaning that the broker determines the value of the position and either adds or deducts that amount of capital in your account. For example, if your contract was valued at $180,000 and fell to $179,000, there would be $1,000 coming out of your account.
If the equity position in your account drops lower than the broker’s margin requirements, more cash will be needed in your account in order to meet the maintenance margin.
In order to avoid taking physical delivery of the underlying asset, your position will probably need to be closed before expiration. If you want to hold your position until it expires, some brokers provide mechanisms that do so automatically.
Once your first futures trade is made, great success can be achieved as you rinse and repeat.
- Easy to bet against the underlying asset. It is easier to sell a futures contract than short sell stocks. You will also gain access to a wider range of assets.
- Simple Pricing. Futures prices are based on the current spot price. They are adjusted for the risk-free rate of return until expiration and the cost to physically store commodities that will be physically delivered to buyers.
- Liquidity: Futures markets are highly liquid. This makes it easy for investors to move in and out of positions without high transaction costs attached.
- Leverage: Futures trading can provide greater leverage than a standard stock brokerage account. For example, you might get 2:1 leverage from a stockbroker and 20:1 with futures. Keep in mind, with greater leverage comes greater risk.
- An easy way to hedge positions: You can protect your business or investment portfolio with a strategic futures position.
- Sensitivity to price fluctuation: You may have to provide more cash to cover maintenance margin if your position moves against you. This will prevent your broker from closing your position. When a large amount of leverage is used, the underlying asset does not have to fluctuate much to require more capital from you. This can result in a potentially huge winner becoming a mediocre trade at best.
- No control over the future: Futures traders are aware that they cannot predict the future. For example, if you are a farmer and sell corn in the fall, but a natural disaster occurs and wipes out your crop it is likely that other farmers will be in a similar situation. As a result, the price of corn will likely increase. This will lead to a significant financial loss as you will have no corn to sell. Speculators are not able to predict all the potential impacts on supply and demand.
- Expiration: All futures contracts come with an expiration date. If the contract expires and you were right on your prediction you might end up with a bad trade. If the contract expired prior to that point, significant capital losses could occur.
Are futures right for you?
To most retail investors, futures have limited value.This value comes from the ability to use more leverage with futures contracts. Leverage does have two sides, gains are amplified but so are losses.
Investing in assets outside of standard stocks, bonds and real estate investment trusts (REIT) futures could be useful. For example, instead of buying an energy stock, you could purchase a futures contract for oil.
Another option could be to invest in an exchange-traded fund (ETF). ETF or Exchange-traded fund tracks the commodity’s value. An expense ratio on the fund might be applied, this will save you from managing futures positions or qualify for a futures trading account.
Most retail investors are more comfortable with a simple buy and hold strategy that does not require a margin account. Futures are a great tool for business and experienced investors.