Futures trading is a way to speculate or hedge against the future value of all kinds of assets, including stocks, bonds, and commodities. Futures trading can provide much more leverage than stock trading, offering the possibility of very high returns but with very high levels of risk.
If you understand how futures markets work and how futures contracts could play a role in your portfolio, they can provide welcome diversification to your holdings.
What are the futures?
When you hear someone use the word “futures” in the financial world, it usually means futures. A futures contract provides terms for the delivery, or cash settlement, of a specified asset such as stocks, commodities, or commodities, on a specified future date. The value of the contract is derived from the value of the underlying asset, making futures contracts a form of derivatives.
Unlike options, futures contracts require the contract holder to settle the contract. This is the main difference between futures and options. Options give the contract owner the right, but not the obligation, to settle the contract.
Futures contracts are especially useful in business. If you own a farm, for example, and you grow corn, you might want to set a price for your corn before it’s time to harvest. This can guarantee a certain level of income for the year, and there will be no surprises if the price of corn tanks. However, it also means that you will not reap the benefits if the price of corn skyrockets before harvest time.
You can buy or sell a futures contract. If you buy the contract, you agree to pay a certain price on a certain date. If you sell a contract, you agree to supply the underlying asset at the price specified.
Understanding the futures
Futures contracts are usually traded on an exchange, which sets the standards for each contract. As the contracts are standardized, they can be freely exchanged between investors. This provides the necessary liquidity to ensure that speculators do not end up taking physical delivery of an oil tanker loaded with oil.
Each contract is for a standard amount of the underlying asset. For example, gold futures trade for 100 troy ounces. So, if gold is trading at around $ 1,800 an ounce, each futures contract is worth $ 180,000. Oil is measured in barrels, or about 42 gallons, and each futures contract is 100 barrels. Corn is measured in bushels, which weigh about 56 pounds, and futures contracts are measured at 5,000 bushels.
Futures contracts also dictate how the transaction will be settled between the two parties to the contract. Will the contract holder physically take delivery of the underlying asset or provide cash settlement for the difference between the contract price and the market price at the time of expiration?
With futures contracts, it is easy for investors to speculate on the future value of any asset traded in the futures market. If a speculator thinks the price of oil is going to skyrocket over the next few months, he can buy a futures contract for three months or more from the current date. When the contract is close to the exercise date, they can easily sell the contract, hopefully for a gain.
Some parties use futures contracts to hedge their positions. A producer can use futures contracts to set a price for his goods. For example, an oil company may want to make sure it gets a specified price on its production for the year and sell oil futures to interested investors.
On the other hand, a company can cover the commodity market it consumes. For example, an airline can buy jet fuel futures. This provides predictable expenses even if the price of jet fuel fluctuates.
Another way to hedge using futures is to have a large and diversified portfolio of stocks and want to hedge against downside risk. You can sell a futures contract on a stock index. This position would increase in value if the stock market fell.
Pros and Cons of Futures Trading
- Easy to bet against the underlying asset. Selling a futures contract can be easier than selling stocks short. Plus, you have access to a wider variety of assets.
- Simple pricing. Futures prices are based on the current spot price and adjusted for the risk-free rate of return until expiration and the cost of physical storage of the goods that will be physically delivered to the buyer.
- Liquidity. Futures markets are very liquid, making it easy for investors to enter and exit their positions without high transaction costs.
- Leverage. Futures trading can provide more leverage than a standard stock brokerage account. You might only get 2: 1 leverage from a stock broker, but with futures you could get 20: 1 leverage. Of course, with greater leverage comes greater risk.
- An easy way to hedge positions. A strategic futures position can protect your business or investment portfolio against downside risk.
- Sensitivity to price fluctuations. If your position moves against you, you may need to provide more liquidity to cover the holding margin and prevent your broker from closing your position. And, when you use a lot of leverage, the underlying asset doesn’t have to move a lot to force you to invest more money. This can at best turn a potential big winner into a mediocre trade.
- No control over the future. Futures traders also run the risk that the future will not be predictable. For example, if you are a farmer and you agree to sell corn in the fall, but a natural disaster wipes out your crop, you will need to purchase a compensation contract. And, if a natural disaster wiped out your crop, you are probably not the only one, and the price of corn has likely climbed much higher, causing a substantial loss in addition to the fact that you have no corn to sell. . Likewise, speculators are unable to predict all the potential impacts on supply and demand.
- Expiry. Futures contracts come with an expiration date. Even if you were correct in your speculative call that gold prices will rise, you could end up with a bad trade if the future expires before that point.
How to trade futures
To start trading futures, you need to open a new account with a broker who supports the markets you want to trade in. Many online stock brokers also offer futures trading.
To access the futures markets, however, they may ask more in-depth questions than when you opened a standard brokerage account. The questions can include details about your investment experience, income, and net worth, all designed to help the broker determine how much leverage they are willing to allow. Futures contracts can be bought with very high leverage if the broker deems it appropriate.
Fees vary from broker to broker for buying and selling futures contracts. Make sure to ask around to find the best broker for you based on prices and services.
Once your account is opened, you can select the futures contract you want to buy or sell. For example, if you want to bet on the rise in the price of gold by the end of the year, you can buy the December gold futures contract.
Your broker will determine your initial margin for the contract, which is the percentage of the contracted value that you must provide in cash. If the contract value is $ 180,000 and the initial margin is 10%, you will need to provide $ 18,000 in cash.
At the end of each trading day, your position is valued against the market. This means that the broker determines the value of the position and adds or deducts this cash amount from your account. If the $ 180,000 contract fell to $ 179,000, you would see $ 1,000 roll out of your account.
If your position’s equity falls below the broker’s margin requirements, you will need to bring more money into the account to cover 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 want to hold your position until it expires.
Once you’ve made your first futures trade, you can rinse and repeat, hopefully with great success.