Futures Trading: What Is It and How Do I Trade It
In finance, a futures contract is defined as a legal agreement between parties to buy or sell something, usually an asset or commodity, at a predetermined price and specified time in the future. A futures contract always represents the fixed amount for an asset or commodity. With commodity trading, two of the best examples of popular and widely traded commodity futures contract today are crude oil and corn.
To date, crude oil has a contract unit of 1,000 barrels while corn’s futures contract is valued at 5,000 bushels which is equivalent to around 127 metric tons of corn.
Future contracts were initially created to give farmers protection against the sudden changes in prices of crops while they are being planted up to the time that they have been harvested and sent to the market. On the other hand, while producers like farmers and the end users still use futures to hedge against potential risks, traders and investors are using all kinds of futures contracts to speculate the asset’s profit trend.
How Futures Work
In the world of finance, a derivative is defined as any financial instrument whose value is derived from another instrument’s price movement. Simply put, the price or value of a derivative depends on the shift in the value of any instrument that it monitors and it isn’t a function of any inherent value. For instance, if a derivative is linked to the S&P 500, its value will be the function of the price movement within the S&P 500.
A futures contract is considered a type of derivative.
As described, a futures contract is a legal agreement between a buyer and seller of an asset or commodity at a predetermined price and time in the future. It is important to know that futures contracts represent the amount of only one specific asset or commodity and its due date. During the trading period, it should be expected that there will be changes in the price of futures contracts depending on the market activities.
Futures contracts may at times require physical asset delivery, while there are some that could be settled in cash. But in general, many traders trade futures contracts to hedge any potential risk or determine the price trend of the asset, not entirely to trade physical commodities. Nowadays, almost all futures contracts are being cash settled and closed without the need for any commodity to be physically delivered.
All futures contracts always have a due or expiration date. Technically, if you’re not able to abandon your position before the specified due date, you will have to deliver the physical commodity if you are in a short position or receive the delivery if you’re in a long position. It should be noted that when nearing the end of the futures contract’s expiration date, the trading value usually increases. However, out the agreement, commodity price charts will rise even more.
Many futures contracts are required to be settled in cash. That is the case if there is no physical commodity to be delivered. It has been calculated that only around 2 percent of futures contracts are being provided physically. That is because many traders or investors are not interested in storing, insuring, and delivering a vast amount of commodity. For this reason alone, contracts are being settled in cash which means that the position will be closed for expiration.
The month when the futures contract expires is called contract month. In some instances, contracts trade every month while there are others that are only traded at specific times.
How Futures Are Different from Other Financial Instruments
Futures contracts and financial instruments are different in many ways. Unlike financial instruments, the value of futures contracts is always decided by the price movement of an asset or commodity. They don’t have any inherent value. Another thing that differentiates futures from financial instruments is that it has a finite life. That is because a futures contract has an expiration date, and the contract will cease to exist after that date. All these only mean that market timing and direction are essential factors of futures trading.
Typically, you will have some options when you are choosing the length of time you want to bet for. For example, there could be corn futures contracts with expiration dates only specified every couple of months within the next year and a half (i.e., November 2017, February 2018, May 2018, August 2018, and November 2018). While extra time may mean larger cost, the longer the futures contracts, the more time investors or traders alike would have to observe the trend. Longer-dated contracts could be more expensive when compared to shorter-dated contracts. At times, longer-dated contracts are also difficult to convert to cash which further increases the buy and sell cost.
Another thing that differentiates futures contracts from financial instruments is that futures traders tend to employ more sophisticated trades. However, the outcomes of these trades will rely heavily on the relationship of different contracts. Furthermore, one could say that perhaps the most crucial difference between futures contracts and financial instruments is how investors use leverage.
How to Trade Futures
If there’s one significant thing to remember when futures trading is that it is not for everyone. Because futures contracts are primarily used not just to hedge other investment but to speculate, the possibility of gaining nothing but substantial losses is as high as ripping significant rewards. That is why it is crucial that you conduct thorough research to know what are about to get yourself into. It is crucial that as a futures trader or investor, you have a solid understanding of how the market works and how contracts function. You should also determine the amount of time, attention, and research you must dedicate to your investment. A better understanding of what cfd futures are is a must as well as knowing the best cfd trading platform. At times like this, it is highly suggested that you talk and seek advice from a broker.
The risk is also something that you should understand and take into consideration. This is to ensure that you are both financially and emotionally prepared to accept any potential financial losses. Always bear in mind that leveraged losses could easily wipe an entire trading account out in just a matter of minutes. Futures traders are generally advised to only use funds that are already set aside as pure risk capital. When we say pure risk capital, this is the amount of money that you can afford to lose.
If you have already decided to enter the world of futures trading, you need to consider the following approaches:
- Do It Yourself
Keep in mind that as an investor, you can always trade your own account without seeking any assistance or help from any broker. However, this action entails the most risk since you automatically become responsible for managing your funds, ordering trades, maintaining the margins, acquiring research data, and lastly, coming up with an analysis of the market movement depending on the asset, commodity, or underlying financial instrument where you invested your fund. This would demand time and a complete focus on the market.
- Open a Managed Account
If you’re so eager to join the market, you should start by opening a managed account which is pretty like an equity account. This would give your broker the authority to trade on your behalf, following, of course, the agreed conditions when the account was opened. This technique could significantly lower the financial risk on your end because an experienced professional will be making informed decisions for you. Still, you would always remain responsible for any incurred losses, as well as for margin calls. Aside from that, you might also pay management fees for the services.
- Join a Commodity Pool
Another way to enter the trading market without any considerable risk is to be a part of a commodity pool. A commodity pool is an enterprise where a group of investors contributes funds for the sole purpose of trading futures. In this method, any profit or losses that you will incur will be directly proportionate to the amount of money that you invested. You will also can invest in a wide range of commodities. Aside from that, you will not even be subjected to margin calls. However, it’s essential that the commodity pool is managed by a highly skilled cfd brokers because risks are still present.
An Introduction to Currency Futures
What are currency futures?
Currency futures are futures contracts used to trade a predetermined amount of a specific currency at a certain price and date in the future. They were first introduced at the Chicago Mercantile Exchange in 1972. Like other futures commodities, they are typically traded depending on contract months. Its standard maturity dates normally fall on the third Wednesday of the months March, June, September, and December.
Currency Futures Exchanges
Currency futures are usually traded on exchanges that offer regulation through centralized clearing and pricing. A far cry from forex where contracts are sold through currency brokers. Do note that regardless of which broker you use, the market price of a currency futures contract will be relatively the same. To date, the largest regulated currency futures marketplace in the world is the CME Group. They offer 49 currency futures contracts which amount to more than $100 billion in daily liquidity. There are also smaller exchanges like the NYSE Euronext, the Brazilian Mercantile and Futures Exchange, and the Tokyo Financial Exchange.
Futures trading is always riskier than to buy and sell stocks. This is the case because of the leverage. Leverage allows any investor to enter a futures position that could be worth more than the required upfront pay. Since the required down payments set by exchanges are sometimes relatively smaller than the value of the actual contracts, futures positions are considered highly leveraged. This set up makes the futures contracts widely popular.
Remember that leverage is seen as a ratio. For instance, gain access to 20:1 leverage and then you put $1,000 in your account, you would be able to enter a position that’s worth twenty times more which is equivalent to $20,000. Technically, if the margin requirement related to the futures contract value is lower, the leverage will be higher.
If there are any changes in the prices, leverage will make gains and losses more substantial than the starting margin. For instance, you purchase an E-mini S&P 500 futures contract that’s trading at 2,600 with a $5,000 market deposit. This would bring the value of the contract to $50 multiplied by the S&P 500 Index which is equivalent to $130,000. In this case, you might win or lose $50.
Now, if the ES goes to 2,700 for a $5,000 gain, that’s good, and your initial investment will amount to $5,000. However, don’t get too excited yet. You also need to think about the consequences if ever the ES drops to the same amount the other way around. If that happens, you’re bound to lose $5,000 or all your investment. Always bear in mind that even the slightest shift in price could lead to huge losses with this kind of leverage.
It’s also important to note that leverage can magnify profits and losses. To limit your losses, you should use a stop-loss order.
What is a Stop-Loss Order?
A stop-loss order is defined as an order placed with a broker to sell a security when it finally reaches a specific price value. They are designed to limit the loss on a position in a security of an investor. While most investors engage in stop-loss order with long positions, it also has the power to protect short positions. In this case, the security will be bought only if it starts trading above a defined price.
A stop-loss order can be beneficial if an investor is away on vacation or cannot watch over his or her position. Also, it could take the emotion out of trading decisions. But, you should know that execution is not always guaranteed, especially in events when the stock trading price halts or gaps (either up or down).
A market order to sell would be initiated when the stock trails below a certain price if an investor chose to use a stop-loss order for a long position. The order will then be filled during the next available price. While this setup works proficiently in an organized market, don’t forget that the market is falling quickly and investors may potentially get a fill which is way below the price of their stop-loss order.