The prices of commodities, stocks and bonds are continually moving up and down, but those movements aren't random. If you can predict these fluctuations correctly, you might reap large rewards from trading in the futures market. Trading futures can also limit your risk, but you have to know what you're doing.
What Are Futures?
Investopedia defines futures as “financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price.” These financial contracts were originally created for farmers to protect themselves from the drastic changes in crop prices throughout the year. Farmers would negotiate deals to sell crops at a certain price at a future date, regardless of the current market price. This would protect both buyer and seller from price fluctuations.
Today, futures contracts still focus on livestock and crops, but they have also expanded to numerous items including gold, oil, treasury bonds and stocks. Even though futures are traded, they are quite different from a regular stock. For example, futures contracts have a set expiration date. This means that by the determined date, all assets must be delivered and the contract must be met. With stocks, there is no determined date.
When working with futures, you will hear the terms long and short. These refer to the two positions of a futures contract. The person with the long position agrees to buy the underlying asset at a certain price when the contract expires. If the market price of the underlying asset has moved higher, the buyer will profit. The short position is on the other side of the contract, selling the underlying asset and profiting if the market price has gone down.
For example, say you take a long position and agree to buy stock futures at $100 a share in three months. Within three months, if the price of the stock goes up to $105, you can sell your futures contract early and make a $5 profit for each share. However, say those shares decreased in value to $97 a share. That means you lose $3 per share, and your loss is the seller's gain.
What Information Is Included in a Futures Contract?
While the terms of each futures contract can vary, each contract should list the quantity of the asset, the selling price and whether the contract will be settled with cash or requires a physical delivery. If the contract specifies physical delivery, this means the actual asset must be delivered by the date specified in the contract and it cannot be traded. Physical delivery is not as common as it was in the past, but it is still used today, particularly when working with agricultural commodities.
Each contract should specify the quantity of the underlying asset. For example, one futures contract could be for 100 bushels of corn or for 50 shares, etc. Due to the varying commodities, each contract will also have different measurements, such as ounces, barrels or even dollar amounts. However, dollar amounts can vary greatly if being traded with countries using different currency.
Forward vs. Futures Contracts
Forward and futures contracts both allow you to buy or sell assets at a later date for a specified price. However, these types of contracts are not the same and can be easily confused. The main difference between a forward contract and a futures contract is a futures contract is traded on a regulated exchange. A forward contract is not traded on an exchange and is simply a private contract between the buyer and the seller.
Where Are Futures Primarily Traded?
There are exchanges around the world that trade a variety of futures, but some focus primarily on certain types of futures. For example, The New York Mercantile Exchange trades energy and food contracts. The Chicago Board of Trade is where most agricultural commodities are traded along with interest rate futures and U.S. treasury notes. Livestock is still a primary focus of the Chicago Mercantile Exchange. A good broker should provide you with all the information you need to know about specific futures contracts and the best exchanges for each kind. Electronic exchanges are also available if you wish to work by yourself, without the help of a broker. Options for electronic exchanges include OneChicago Exchange, which is where you can trade single stock futures. Intercontinental Exchange is another electronic trading platform for trading global futures.
What Are the Risks of Trading Futures Contracts?
If you know what you're doing, trading futures isn't any riskier than other investment options. However, the leverage involved in futures trading means profits and losses can come quicker than if you were investing directly in the underlying asset.
Understanding leverage is crucial when working with futures. When you pay for a futures contract, you buy on a margin. This means you only pay a certain percentage of the price of the asset. With futures, you can pay as little as 10 or 15 percent. This means that you can receive high reward with these contracts or lose big. If you plan to trade futures contracts, you need to be wise with your money and use stop-loss orders to prevent any large losses. A stop-loss order is when a broker must sell once a share has reached a certain price. This allows you to exit an underperforming investment before the losses become too great to handle.
When trading futures, poor money management can cost you greatly. Because there are risks involved with trading futures and it is possible to lose substantial amounts of money, experts recommend you only trade with money you can afford to lose. This money is called risk capital. You will want to talk to an experienced broker before jumping into the futures arena to ensure you understand the risks and to guide you throughout the process.
What Else to Consider Before Trading
Before you begin trading futures, there are several things to consider. The first thing is to establish a trading strategy. If you trade stocks, you may have a trading strategy already. However, that same tack might not work with futures trading.
As with stock trading, it's helpful to watch market trends, factoring in interest rates and bond yields. Be sure to pick time frames you're comfortable with, whether you're better at predicting short-term or long-term market movements.
As a beginner, it is also wise to choose futures categories you are familiar with. There are several categories, including agriculture, energy and equity indexes. Within these categories there are more specific sectors such as livestock or natural gas. Once you have chosen your category and instrument, you can narrow it down to your contract. You will want to research all of these contracts carefully as they can differ greatly by their volatility, margin requirements, liquidity, etc. This research can, and should, take a considerable amount of time to ensure you are making the right investment.
As with any investment, be aware of the risks before you start trading. There are conservative and aggressive futures strategies, but even aggressive traders should only risk money they can afford to lose – especially if they are inexperienced in futures trading.
Where Do I Trade Futures?
One of the most common ways to trade futures is to open a managed account at a brokerage firm. Experienced traders will do the trading for you, which can minimize your risk. You have to pay a fee for the convenience, but this is one of the smartest options for conservative traders. Other options include trading on your own with an online brokerage company. These companies usually have small fees, but you will be doing most of the work yourself.
You can also day trade futures if you desire. However, this is an extremely risky option, particularly if you are choosing to day trade futures on your own, without an experienced broker or investor assisting you. Day trading futures requires extensive research on purchases and margins. You also must have a strong knowledge on when is the best time sell or buy futures to reap any reward.
What Is the Process for Trading?
After all your research and trading process plans are finalized, the actual process for trading futures is fairly simple. The first steps to trade that require the most effort include:
1. Select the asset you wish to trade.
2. Find an experienced and knowledgeable broker.
3. Discuss your trading plans and strategies with your broker.
4. Make your margin deposit on the futures with the broker.
After you have made your deposit, the broker takes over. The broker will trade the asset with the clearinghouse. You will want to work with the broker to ensure your trading strategy is working and to discuss any changes.
How to Find the Best Brokers for Futures
An experienced and knowledgeable broker is key to trading futures. The wrong broker can put you in hot water and limit your gains. As you look for the best broker for trading futures, there are a few things to consider.
How long has the broker been trading futures? What is their success rate? You need a broker who understands what they are doing and has a track record to show that their trading strategies work.
Ensure your broker or firm is registered with the National Futures Association. The NFA establishes and enforces rules regarding the trading of futures. It is mandatory that all brokers trading futures are members, to ensure that everyone trading futures plays by the same rules. Also, check with the Commodities Futures Trading Commission to ensure your broker or firm is registered. The CFTC’s responsibilities include protecting users from fraud and vicious and unethical practices.
How much money will you be paying your broker for their services? It is wise to compare costs between several brokers before you make any final decisions. The cost of services and attached fees can be excessively high if you are not careful.
Do your research on the firm to determine if any complaints have been made regarding the firm and its brokers. The last thing you want to do is give your money away to a thief.
Trading futures, if done correctly, can produce big rewards. However, it can also bring about large losses. Before making any final decisions, do your research and talk to a licensed broker to determine if trading futures is the right step for you to take.