What is Futures Trading?
If you have recently looked at a financial website or newspaper, you may have come across the term “futures”. Let’s begin with the definition of futures:
Futures are financial contracts that obligate the parties to buy or sell an asset at a certain price by a set future date. This means that at the expiration date of the futures contract, the buyer must purchase or the seller must sell the underlying asset at the set price agreed to in the contract, regardless of the market price at the end of the contract. It is most likely that the agreed-upon price in the contract will not be the same as the market price at the end of the contract.
What types of assets can the parties agree to trade in futures trading? Well, there is really no limit in this regard, but there are certain assets that are popular to trade. Generally, future traders deal in physical commodities (such as gold or oil or even hogs) or other financial instruments (such as stock markets indices, currencies or bonds). Bitcoin has been in the news as the cryptocurrency continues to hit new heights, and yes, one can trade bitcoin futures as well.
The key points to remember are that a futures trade will be regulated by a contract (“futures contract”), and the buyer and sell are locked in a price for the asset until the expiration date of the contract.
Let’s look at a simple example of a futures trade. Suppose it is currently April, and the buyer wishes to buy 1,000 barrels of oil now, but only take delivery in July. The buyer would enter a July crude oil futures contract at an agreed-upon price upon the July expiration, regardless of the market price in July. Likewise, the seller of the contract has agreed to deliver 1,000 barrels in July at the agreed-upon price. The important point to remember is that both parties have an obligation to fulfil the requirements of the contract at the end of the contract term, which is the expiry date. Since the duration of the contract is for 3 months, this is known as a 3-month futures contract.
Why trade futures?
Now that we have an understanding of what a futures trade is, let’s look at which participants would be interested in conducting such a trade.
- Traders/Investors
A private trader or investor may wish to speculate on of the direction of the market price of a particular asset. This can be done by entering a futures contact. Essentially, the buyer is making a bet on the price movement of the underlying asset by purchasing a futures contract. For example, suppose that a trader believes that gold prices will be much higher in three months time. He proceeds to purchase a future contract now. If gold prices did indeed rise, Smith will have made a profit, as he purchased the gold for less than the market price at the end of the contract. - Companies
A company may use a futures contract in order to lock in a price. For example, an airline company wants to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract, agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.This is known as hedging. Unlike, the example above with the trader who is speculating and looking to make a profit, the company is not speculating on the price of oil in three months time but is purchasing a futures contract so that it will know with certainty the price of oil at the end of the (3-month) futures contract.It should be noted that individual traders who enter future contracts are not interested in the actual delivery of the underlying asset – as we mentioned earlier, they are speculators, looking to make a profit on market movement. Most likely, the trader would sell his contract to another buyer prior to the expiration of the contract, hopefully at a profit. Technically speaking, however, if the trader is still holding onto the contract at its expiration, he would be legally bound to accept delivery of the asset. It goes without saying that a trader who has entered a futures contract would have no interest in accepting delivery of 1,000 barrels of oil or 5,000 hogs!
How to trade futures
Futures trading takes place on a futures exchange, which is a centralized marketplace where futures contracts are bought and sold. Future contracts can only be traded through a futures exchange. New York, Chicago and London are among the largest future exchanges in the world. Years ago, the actual trades would take place on the trading floors of the exchange houses. With the advances in technology, trades are now executed through an electronic system.
A futures contract is standardized, which means that all the terms of the agreement are set out, except for the price, which is constantly changing. If two parties enter into a futures contract, the price of the contract is determined on the exchange and the parties agree to enter the contract at this price.
Are you ready to trade futures?
Every day, each of us has to deal with the issue of time vs. money. Time is a finite resource, so when you are paid for your job, you are “trading” time for money. The income that you are earning is limited by the number of yours that you work. As a trader, however, your profit on a single trade could be as much as your income from hours of work! Thus, future trading enables you to increase your money at a much faster rate than if you were working. Trading has its risks, of course, but as you develop a successful trading strategy, you will increase your earning potential.
Risk
Future trading can be profitable, but at the same time entails risk. As a trader, you will need to become familiar, and comfortable, with leverage and margin rules. These rules are more liberal for future trading than say, trading stocks. A futures broker may allow you to leverage your trades by 10:1 or even 20:1, which means that by putting down a small amount of cash, you can control a much larger position. Leverage must always be managed carefully – greater leverage means that you can make greater profits, but at the same time, the potential for losses is also greater.
Define Your Risk Tolerance
Any trader will tell you that “you win some and lose some”. Of course, we like to think that a trade we make will be a winner, but it is always prudent to keep in mind the potential loss of a trade. Risking all of your capital on one trade is never a good idea. Risk tolerance will vary from trader to trader, so you will need to define how much risk you can live with. An old rule of thumb for how to trade is that if you are losing sleep over a trade that you made, then it was too risky a move.
Any type of financial trading has a built-in amount of risk, as any trade can result in a profit or a loss. The greater your understanding of futures trading, the better your chances at succeeding. As we have learned, future trading carries significant risk; therefore, it is imperative to enter such trades only if you are comfortable with the risk involved.
Watch this video: Investing Basics- Futures (05mins 58secs)
Learn to trade futures
Futures trading can easily be done on the internet. In order to get started trading futures, you will need to open an account with a futures broker. Since futures trading is based on leverage and margins, these types of trades carry significant risk. It is therefore highly recommended to use a broker that provides a virtual trading account, which is also called a demo trading account. This allows you to practice trading with “paper money”, which is an excellent method of making sure that you understand how the futures market works before you commit real dollars to an actual trade. A virtual trading account is invaluable for the novice trader, but it can also be useful for an experienced trader who wants to try out a new trading strategy.
It is important to keep in mind that futures brokers will provide varying services. Thus, it is critical to choose a broker that you are comfortable with and that provides you with the services and support that you need as a trader. You can easily access dozens of futures brokers on the internet, all who are eager to sign you up as a client. Before you commit, do you research so that you find a futures broker that suits your needs.
Summary
Future trading involves purchasing contracts of underlying assets, with the aim of profiting from the movement in market price. In order to trade large positions without having to put down large amounts of capital, traders utilize leverage. In order to be successful as a trader, it is essential to develop a trading strategy that matches your needs, goals and risk tolerance.
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Hopefully, you have enjoyed today’s article. Thanks for reading! Have a fantastic day!
Nisha Patel
Live from the Platinum Trading Floor.