Futures trading is a way to speculate on or hedge against the future value of all types of assets, including stocks, bonds and commodities. Trading futures can offer much more leverage than trading stocks and offers the opportunity for very high returns but with very high risk.
Understanding how futures markets work and how futures might play a role in your portfolio can add welcome diversification to your holdings.
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What are futures?
When you hear someone use the word “futures” in the financial world, they usually mean futures contracts. A futures contract provides terms for the delivery or cash payment of a specific asset, such as B. stocks, commodities or products, at a certain date in the future. The value of the contract is derived from the value of the underlying asset, making futures a form of derivative.
Unlike stock options, futures require the contract holder to perform the contract. This is the main difference between futures and options. Options give the contract holder the right – but not the obligation – to perform the contract.
Futures are particularly useful in business. For example, if you own a farm and grow corn, you might want to set a price for your corn before it’s time to harvest. This can guarantee some income for the year and there will be no surprises when the price of corn tanks increases. However, it also means that if the price of corn shoots up before harvest time, you won’t benefit.
You can buy or sell a futures contract. When you buy the contract, you agree to pay a specific price by a specific date. When you sell a contract, you agree to deliver the underlying asset at the agreed price.
understand futures
Futures contracts are typically traded on an exchange, which sets the standards for each contract. Because 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 a tanker load of oil.
Each contract is for a standard amount of the underlying asset. For example, gold futures trade contracts for 100 troy ounces. So if gold is trading at around $2,000 an ounce, each futures contract is worth $200,000. Oil is measured in barrels, which is about 42 gallons, and each futures contract is 100 barrels. Corn is measured in bushels, which weigh about 56 pounds, and futures contracts are standardized to 5,000 bushels.
Futures contracts also dictate how trading between the two contracting parties will be settled. Does the contract holder take physical receipt of the underlying asset or provide cash settlement for the difference between the contracted price and the market price at the time of expiry?
With standardized futures contracts, it is easy for investors to speculate on the future value of assets traded in the futures market. If a speculator believes that oil prices will increase in the next few months, they can buy a futures contract for three or more months from the current date. If the contract is close to the exercise date, they can easily sell the contract, hopefully for a profit.
Some parties use futures contracts to hedge their positions. A producer can use futures contracts to set a price for its goods. For example, an oil company wants to make sure it gets a certain price for its production for the year and sell oil futures to interested investors.
On the other hand, a company could hedge the market for raw materials it consumes. For example, an airline can buy futures on kerosene. This ensures predictable expenses, even if the price of kerosene fluctuates.
Another way to hedge with futures is if you have a broad and diversified stock portfolio and want to hedge against downside risk. You could sell a stock index futures contract. The position would increase in value if the stock market fell.
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Pros and cons of trading futures
Advantages
- Simply bet against the underlying asset. Selling a futures contract can be easier than shorting stocks and gives you access to a wider range of assets.
- Simple pricing. Futures prices are based on the current spot price and are adjusted for the risk-free yield to expiration and the cost of physical storage for commodities that are physically delivered to the buyer.
- Liquidity. Futures markets are very liquid, making it easy for investors to enter and exit positions without high transaction costs.
- leverage. Futures trading can offer greater leverage than a standard stockbroker account. You might only get 2:1 leverage from a stockbroker, but you could get 20:1 leverage with futures. 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 from downside risks.
Disadvantages
- Sensitivity to price fluctuations. If your position moves against you, you may need to put up more cash to cover maintenance 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 very much to force you to invest more money. This can turn a potential big winner into a mediocre trade at best.
- No control over the future. Futures traders also carry the risk that the future is unpredictable. For example, if you are a farmer and agree to sell corn in the fall, but then a natural disaster destroys your crops, you need to buy an offset contract. And if a natural disaster wipes out your crops, you’re probably not the only one, and the corn price has probably gone up a lot higher, resulting in a significant loss on top of not having any corn to sell. Likewise, speculators cannot foresee all potential effects on supply and demand.
- Process. Futures contracts have an expiry date. Even if you were correct in your speculative view that gold prices will rise, you could end up with a bad trade if the contract expires before that time.
How to trade futures
To start trading futures, you need to open a new account with a broker that supports the markets you want to trade. Many online stock brokers also offer futures trading.
However, to gain access to the futures markets, they may ask more in-depth questions than when opening a standard stockbroker account. Questions may include how much money do you need to start futures trading, details of your investment experience, income and net worth, all aimed at helping the broker determine the amount of leverage that he is willing to allow. Futures contracts can be bought with very high leverage if the broker deems it appropriate.
Fees for buying and selling futures vary from broker to broker. Make sure you shop around to find the broker that is best for you based on price and services.
Once your account is opened, you can choose the futures contract you want to buy or sell. For example, if you want to bet on the price of gold rising by the end of the year, you could buy the December gold futures contract.
Your broker determines your initial margin on the contract, which is usually a percentage of the contract value that you must provide in cash. If the value of the contract is $180,000 and the initial margin is 10%, you must provide $18,000 in cash.
At the end of each trading day, your position is valued at the market price. This means that the broker determines the value of the position and adds or deducts that amount in cash from your account. If the $180,000 contract fell to $179,000, you would see $1,000 withdrawn from your account.
If the equity in your position falls below the broker’s margin requirements, you will need to put more money into the account to meet the minimum margin.
To avoid physical delivery of the underlying asset, you will likely need to close your position before expiry. Some brokers have mechanisms in place to do this automatically if you wish to hold your position until expiry.
Once you’ve made your first futures trade, you can flush and repeat, hopefully with great success.
Is the future right for you?
Futures have limited value for most retail investors. Value comes from the ability to gain more leverage with futures contracts, but leverage is a double-edged sword. Your winnings will be magnified, but so will your losses.
However, futures could be useful for investing in assets outside of standard stocks, bonds, and real estate investment trusts (REITs). For example, instead of buying an energy stock, you could buy an oil futures contract.
Alternatively, you can invest in an exchange traded fund (ETF) that tracks the value of the commodity. While you may have to pay an expense ratio for the fund, it saves you having to maintain a futures position or qualify for a futures trading account.
While futures are a great tool for corporate and advanced investors, most retail investors are better off with a simple buy-and-hold strategy that doesn’t require a margin account.
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