Are you familiar with forex trading? You probably hear the name of futures trading. Let’s read this guide and learn about the concept of futures contracts and how it works in the financial market.
What are Futures?
A futures contract, also referred to as a future, is a derivative product that is traded on the stock exchange. These contracts are based on fundamental assets such as commodities, currencies, or stock indices. It is crucial to note that future trading does not include the physical trading of actual commodities. Rather, traders engage in contracts that deal in cash, terminating the need for physical delivery of the goods.
What is a Futures Contract?
A future contract is a legal, financial instrument that binds a purchaser and a seller. While the purchaser takes a long position in the derivative, expecting that the price of the fundamental asset will increase. Meanwhile, the seller sells, expecting that the fundamental asset’s price will decrease. Futures contracts come with a predetermined expiry date.
With futures trading, the purchaser expresses their desire to purchase the derivative on or before the expiry of the agreement. As the agreement nears its expiration date, the fundamental asset’s price determines the value of the future contract. If the asset price is above the strike price of the derivative, it is considered in the money, and the purchaser wins the trade. However, if the asset price remains lower than the strike price of the derivative, the seller wins the trade.
What Types Of Futures Exist?
There are several kinds of futures contracts available for trading. The perfect sector for future trading is the commodity sector, which includes agricultural commodities, energy commodities, and metals. Furthermore, futures contracts can be traded on currencies, bonds, indices, and even cryptocurrencies.
- Agricultural Futures: These were the authentic futures available at markets such as the Chicago Mercantile Exchange. Additionally to grain futures, there are also tradable futures contracts in fibers like cotton, rice, corn, milk, coffee, sugar, and even livestock.
- Energy Futures: They deal with exposure to the most common fuels and energy products, like crude oil, natural gas, heating oil, and gasoline.
- Metal Futures: These types of contracts trade in industrial metals, like gold, silver, platinum, steel, copper, etc.
- Currency Futures: They provide exposure to changes in the exchange rates and interest rates of various national currencies such as the dollar, euro, yen, etc.
- Financial Futures: Agreements that trade in the future value of a security or index. For instance, there are futures for the S&P 500 and Nasdaq indexes. There are also futures for debt products like T-notes and T-bonds.
- Cryptocurrencies Futures: These types of contracts are traded in cryptocurrencies like Bitcoin, Ethereum, Litecoin, etc.
How Futures Trading Works
Select a Broker and Open a Trading Account
Getting started in futures trading requires traders to open a new account with a reputable broker that supports their desired market. The platform may ask more in-depth questions than when you opened a standard brokerage account.
However, questions are inquiring about details of your income, net worth, and investing experience. With all of this information, brokers will determine the amount of leverage they are capable of allowing you.
Open Your First Future Trade
Once your trading account is open, you can choose the future contract you would like to buy or sell. For instance, if you want to bet that the price of crude oil is climbing by the end of the year. You could purchase the December crude oil future contracts.
Your broker will set your initial margin of the contract, which is usually a percentage of the contract you require to deposit at the time of contract. If the value of the contract is $150,000 and the initial margin is 10%, you will need to deposit $15,000 in cash.
At the end of every trading day, your position is ticked to market. It means the broker determines the value of the position and cuts and adds that amount in cash to your account. If the $150,000 contract fell to $149,000, you would see $1,000 come out of your account.
Suppose the equity in your position falls less than the broker’s margin requirements. You will be required to bring more funds to the account to meet the maintenance of margin.
The Risks of Futures Trading
All investing comes with a component of risk, but future trading contracts. It can be an untrustworthy way for individual investors with finite knowledge of how the future works.
- Leverage: Brokers will allow traders to trade futures on margin, which appropriately allows you to borrow money to place bigger trades. If that trade does not succeed, you are on the hook for a larger sum of money than you may be ready to pay.
- Price Swings: The major risk for futures investors is that the fundamental asset that they hold the futures contract on moves on the contrary direction of their deal.
- Crypto Futures: As recently launched cryptocurrency funds come to market, be advised that these holds have a large amount of future contracts rather than fundamental cryptocurrencies. The extreme level of volatility means that remarkable performance unevenness is sure to result.
Difference Between Futures and Forwards Trading
A forward contract is quite similar to a future contract. Where a purchaser and seller agree to fix a price and quantity of a product for delivery at a future date, both types of agreement can be used for speculation and hedging.
However, there are significant differences. A future agreement is a standardized contract that can be traded on an exchange. In contrast, the forward agreement is simply a private contract between both parties. Therefore, it is possible to trade forwards on over-the-counter (OTC) markets, and they are less regulated and less reachable to retail investors. It means that there are great opportunities to customize a forward contract according to the buyer and seller preferences.
Final Words
In this article, we have shared an in-depth concept of Futures trading and how it works. It is not rocket science, but it does need a level of understanding before you dive in. However, it is an outstanding instrument to place your bets as a hedger or speculator.
