Futures trading: what it is and how to get started

What are futures?

Futures are derivative contracts to buy or sell an asset at a future date at an agreed price.

This asset can be soybeans, coffee, oil, individual stocks, exchange-traded funds, cryptocurrencies, or a number of others. Futures contracts can be used by many types of financial actors, including investors and speculators, as well as companies that actually want to receive or deliver the commodity.

oil, for example, is a commodity that can be traded in futures contracts. Investors can also trade S&P 500 futures contracts – an example of investing in stock futures.

What is a futures market?

A futures market is an exchange where investors can buy and sell futures contracts. In typical futures contracts, one party agrees to purchase a specified quantity of a security or commodity and receive delivery on a specified date. The seller undertakes to provide these.

According to the Commodity Futures Trading Commission, most participants in the futures markets are consumers or commercial or institutional commodity producers. Commodity futures and options must be traded on an exchange by persons and firms registered with the CFTC.[0]

Use of futures

Futures contracts allow players to lock in a certain price and protect themselves from potentially wild price swings (up or down). To illustrate how futures work, consider kerosene:

• An airline that wants to freeze kerosene prices to avoid an unexpected spike might do so buy a futures contract Agreement to purchase a specified amount of kerosene for future delivery at a specified price.

• A fuel rail can sell a futures contract to ensure it has a stable market for fuel and to protect against an unexpected price drop.

• Both sides agree on specific conditions: Buy (or sell) 1 million gallons of fuel, delivered within 90 days, at a cost of $3 per gallon.

In this example, both parties are hedgers, real corporations who need to trade the underlying commodity as it is the basis of their business. They use the futures market to manage their exposure to price changes.

But not everyone on the futures market wants to exchange a product in the future. These people are futures investors or speculators trying to make money from price changes in the contract itself. If the price of jet fuel goes up, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract with no intention of taking the underlying commodity; You are only in the market to bet on price movements.

As speculators, investors, hedgers, and others buy and sell on a daily basis, there is a buoyant and relatively liquid market for these contracts.

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Investing in stock futures

Commodities make up a big part of the futures trading world, but it’s not just about hogs, corn and soybeans. Stock futures investing allows you to trade futures of individual companies and stocks of ETFs.

Futures contracts also exist for bonds and even Bitcoin. Some traders like futures trading because they can take a sizeable position (the amount invested) while raising a relatively small amount of cash. This gives them greater leverage potential than just owning the securities outright.

Most investors consider buying an asset with the expectation that its price will increase in the future. But short sale lets investors do the opposite – borrow money to bet that the price of an asset will fall so they can later buy it at a lower price.

A common application for futures relates to the US stock market. Someone who wants to hedge their equity exposure can short a futures contract on the Standard & Poor’s 500. When stocks fall, they make money shorting them and offsetting their exposure to the index. Conversely, that same investor can look to the future with confidence and buy a long contract — and gain plenty of upside potential as stocks rise.

What are futures contracts?

Futures contracts, which you can easily buy and sell through exchanges, are standardized. Each futures contract will typically specify all of the various contract parameters:

• How the trade is settled – either by physical delivery of a specified quantity of goods or by cash settlement.

• The quantity of goods to be delivered or covered by the contract.

• The currency unit in which the contract is denominated

• The currency in which the futures contract is quoted.

• Rating or quality considerations, if applicable. This can be, for example, a specific octane number for petrol or a specific purity for metal.

If you want to start trading futures, be careful as you don’t want to take physical delivery. Most casual traders don’t want to be obliged to sign a trainload of hogs at the end of the contract and then figure out what to do with it.

The Risks of Futures Trading: Margin and Leverage

Many speculators borrow a significant amount of money to play in the futures market as this is the primary way to magnify relatively small price movements to potentially make profits that justify the time and effort.

But borrowing money also increases risk: if the markets move against you, and more dramatically than expected, you could lose more money than you invested. The CFTC warns that futures are complex, volatile, and not recommended for retail investors.

Leverage and margin rules are much more permissive in the futures and commodities world than in the securities trading world. A commodities broker can give you leverage of 10:1 or even 20:1 depending on the contract, much higher than you could get in the stock world. The stock market sets the rules.

The greater the leverage, the greater the gains, but also the greater the potential loss: a 5% price change can result in an investor with 10:1 leverage gaining or losing 50% of their investment. This volatility means speculators need discipline to avoid taking undue risk when investing in futures.

If such risk seems too high and you are looking for a way to change your investment strategy, consider options trading instead.

How to start trading futures

Getting started trading futures is relatively easy. Open an account with a broker that supports the markets you want to trade. A futures broker will probably ask you about your experiences with investing, income and wealth. These questions are designed to determine the level of risk that the broker will allow you to take in terms of margin and positions.

There is no industry standard for commission and fee structures in futures trading. Each broker offers different services. Some offer a lot of research and advice, while others just give you a quote and spreadsheet.

Some websites allow you to open a Paper Trading Account. You can practice trading “paper money” before using real dollars for your first trade. This is an invaluable way to review your understanding of the futures markets and how the markets, leverage and commissions interact with your portfolio.

If you are just starting out, we strongly recommend that you spend some time trading on a virtual account until you are sure you get the hang of it.

Even seasoned investors often use a paper trading account to test out a new strategy. Some brokers may grant you access to their full range of analytical services in the paper trading account.