Futures trading has several advantages, such as high leverage and low transaction costs. Companies can hedge the price of their commodities to protect their current prices, while retail investors can profit from price fluctuations in the underlying asset.
However, futures trading is risky and not very suitable for beginners. Due to the leverage effect, investors are either making their profits more amplified or they can magnify their losses.
This article covers the basics of what is trading futures, how trading futures work, their benefits and risks, and more.
Table of Contents
- What are Futures?
- Uses for Futures
- What is Trading Futures?
- Types of futures
- Why do people trade futures?
- What are the Pros and Cons of Trading Futures?
- Options on futures
- Future Contracts vs Options Contracts
- FAQs: Frequently Asked Questions
What are Futures?
A futures contract is a type of derivative contract to buy or sell a particular commodity or security at a specified price on a specified future date. Futures contracts, or simply “futures,” are traded on futures exchanges such as CME Group and require a brokerage account licensed to trade futures.
Futures contracts, like options contracts, involve both a buyer and a seller. Unlike options, which can become worthless when they expire, once a futures contract expires, the buyer is obligated to purchase and receive the underlying asset, and the futures contract seller is obligated to provide and deliver the underlying asset.
Uses for Futures
Generally, there are two uses of Futures in investing:
Risk Management (Also known as Hedging)
Futures contracts are bought or sold for the purpose of receiving or delivering an underlying commodity and are typically used by institutional investors or corporations for hedging purposes. It is often used as a way of hedging or to manage the future price risk of that commodity in its operations.
Futures contracts are generally liquid and can be bought or sold until the expiration date. This is an important feature for speculative investors and traders who do not own or do not want to own the underlying asset. You can buy and sell futures to express your opinion about the direction of the market for your commodity and profit from it. You then buy or sell your offset futures contract position before it expires to eliminate your obligation to the actual commodity.
What is Trading Futures?
Futures are traded on futures exchanges such as the CME (Chicago Mercantile Exchange), and investors must have an approved brokerage account. In other words, a futures contract fixes the current price of a commodity or stock and defines the current fixed cost of the underlying asset and its expiry date.
Brokers only charge a portion of the initial investment. This is part of the total contract amount, usually, 3% to 10%, called the initial margin. The trading provider or broker borrows the remainder to complete the total contract amount.
Futures exchanges set an initial margin, but brokers require you to have additional funds in your account known as maintenance margin. A minimum amount must always be in the account, usually between 50% and 75% of the initial margin.
If the amount falls below the minimum margin. For example. If the price goes against the trade, the broker will send a margin call to the trader asking him to deposit additional funds to restore the original margin to his level. A futures contract obliges both parties to buy or sell the underlying asset.
Finally, futures contracts are commonly used by two types of investors namely Hedgers and Speculators. A hedger is an institutional investor who wants to hedge the current price of the commodities they use in their production through commodity futures trading. Speculators are retailers who have no interest in the actual physical product but want to profit from price fluctuations.
Types of futures
Tradeable futures types include a wide range of financial and commodity-based contracts, from indices, currencies, and debt to energy, metals, and agricultural commodities. Here are some examples of available futures contracts:
Index contracts & interest rate contracts are two types of financial futures contracts. An index contract provides exposure to a specific market index value and an interest rate contract provides exposure to the interest rate of a specific debt instrument.
Some of the Financial Futures are:
- E-Mini Nasdaq
- E-Mini Mid-Cap 400
- E-Mini S&P 500
- Mini Dow Jones
- U.S 10-Year Notes
- Nikkei 225 (CME)
Currency contracts provide exposure to real currency or cryptocurrency exchange rates.
Some of the Currency Futures are:
- British pound
- Canadian Dollar
- CME Bitcoin
- New Zealand Dollar
- Australian Dollar
Energy contracts provide access to prices for common energy products used by businesses (for manufacturing, production, and/or transportation), governments, and individuals for consumption purposes.
Some of the Energy Futures are:
- Natural Gas
- Crude Oil
Metals contracts provide exposure to the price of specific metals that many companies rely on as materials in their manufacturing and construction (e.g., gold in computers or steel in houses).
Some of the Metal Futures are:
- Gold & Silver
Grain contracts provide exposure to the price of grain commodities used for commercial processing into animal feed and other products (such as ethanol and corn syrup) and processed soybeans.
Some of the Grain Futures are:
- Soybean Oil
Livestock contracts provide access to prices for live animals used in the supply, processing, and distribution of meat products.
Some of the Livestock Futures are:
- Live Cattle
- Lean Hogs
- Feeder Cattle
Food & Fiber Futures
These contracts provide access to the price of certain agricultural commodities being grown, extracted, or mined and the price of dairy products.
Some of the Food & fiber Futures are:
Why do people trade futures?
Retail investors and traders most commonly use futures to speculate on future price movements of underlying assets. They seek to profit by giving their opinion on where the market is headed for a particular commodity, index, or financial instrument. Some investors typically use futures as a hedge to offset future market movements in certain commodities that may affect their portfolio or business.
Of course, stocks and ETFs can also be used to speculate on future market movements or to hedge. While each has its own set of risks to be aware of, the futures market offers some distinct advantages over the stock market.
What are the Pros and Cons of Trading Futures?
Pros of Trading Futures
To open an equity position in your margin account, you must deposit at least 50% of the total amount. For futures, the required initial margin amount is typically set at 3-10% of the underlying contract value. This leverage gives you the potential to earn a higher return relative to the amount invested but also exposes you to the risk of losing more than your initial investment.
Futures offer an opportunity to diversify your investments in a way that stocks and ETFs cannot. They provide direct market exposure to the underlying commodity assets. Secondary market products such as stocks. Additionally, you have access to specific assets not typically found in other markets. Futures can also be used when looking for strategies designed to manage the risks associated with upcoming events that could move the market.
In the future, the margin requirements for long and short positions are the same, so a bearish hold or position reversal is possible without additional margin requirements.
Futures may offer potential tax benefits compared to other short-term markets. This is because profitable futures trading is taxed at 60/40.
60% of profits are taxed as long-term capital gains and 40% as ordinary income. In contrast to stock trading, gains on stocks held less than 1 year are taxed at 100% as ordinary income.
Cons of Trading Future
- Futures trading can provide excellent investment opportunities, but it also carries a high degree of risk. The downside of trading futures is that the process isn’t as straightforward as other strategies and it’s easy to make common investment mistakes.
- Speculators risk losing more money than their initial margin due to leverage. Because the profit doubles, but the loss also doubles.
- Hedger can lose price declines by hedging the current price through futures contracts.
- Beginners should do their research before trading futures.
Options on futures
Options on futures contracts work in the same way as options on stock contracts. You can also use some of the same options strategies. Futures trading options include market-neutral, multi-leg and directional trading, depending on how you think the market will behave and your risk/reward objectives.
ne of the benefits of options on futures is that they can de-risk your portfolio in a number of ways. If you want to trade uncorrelated markets to diversify your risk, hedge your existing positions to limit your risk, or trade more volatile markets directly at a lower cost than just futures contracts, futures Options can.
Future Contracts vs Options Contracts
Unlike option contracts, where the holder has the right to buy or sell the underlying asset at any time before the expiration date of the contract, futures contracts require the buyer to acquire the underlying asset at maturity rather than before it expires.
A futures contract requires the buyer or seller to buy or sell an asset at a specific, agreed-upon future date and price specified in the contract. However, the holder can close the position before the maturity date.
The main difference is that an option contract, as the term suggests, gives the trader an option rather than an obligation to exercise the right to buy or sell a stock at a specified price as well as the maturity date of the contract. This is a type of stock compensation and is a common form of employee compensation in the form of employee stock options (ESO). The similarity is that futures contracts allow you to exercise your right to sell your position at any time before expiration to relieve yourself of the obligation to purchase the asset. Therefore, buyers of both options and futures contracts can close their positions and leveragers can profit from closing their positions.
If you are considering trading futures, you should first familiarize yourself with all the processes including trading fees, leverage, and obligations. Going with a trusted broker and familiarizing yourself with the different underlying of futures contracts is also important.
Online brokers usually provide all the information you need on their website, but we recommend double-checking with the broker first.
Overall, technical analysis is recommended when estimating futures underlying prices. As a beginner, start small, choose a reputable broker, and choose the asset class you are most comfortable with.
FAQs: Frequently Asked Questions
What is futures trading?
Futures trading is facilitated by futures exchanges such as the Chicago Mercantile Exchange (CME) and requires investors to have an approved brokerage account. When a trader or firm enters into a futures contract, it obliges them to buy or sell the underlying asset at a specified price and date in the future.
Companies use this tactic to know the current price of the goods they use to produce, to avoid price increases, or to profit from price fluctuations by individual investors.
What are futures contracts?
A futures contract can fix the current price of an asset at a fixed price at a specified time in the future. Futures contracts derive value from underlying assets, either commodities such as gold, profits, water, and oil, or financial stocks such as stocks and bonds.
What are the main benefits of futures trading?
Futures trading is leveraged, allowing investors to trade larger sums than their initial investment. This means less capital is required to participate in trading. Other benefits include dependence on actual prices, tax benefits, and reduced transaction costs.
Is futures trading risky?
Futures are leveraged, so an investor does not have to invest the full amount of the stock to participate in the trade. Futures trading is also riskier, as investors risk losing more money than they have invested, even with a low initial margin, if the trade goes unfavorably.