Futures trading is a key element in the world of financial markets. As a way to hedge, speculate, and invest, it holds a significant place among various trading and investment strategies. However, many beginners or even experienced traders might still find futures trading complex and difficult to grasp. In this article, we’ll explore what futures trading is, how it works, and why it’s an essential component of global markets. We’ll also answer some frequently asked questions (FAQs) and conclude with the key takeaways.
Key Takeaways
- Futures contracts are standardized agreements to buy or sell an asset at a specified future date and price.
- Hedging and speculation are two primary reasons why people trade futures.
- Futures provide significant leverage, allowing traders to control larger positions with less capital, but also increasing potential risks.
- Margin calls and daily mark-to-market settlements are essential to understanding how futures trading works.
- While futures trading offers the potential for diversification and profit, it also comes with substantial risk due to price volatility and leverage.
Understanding Futures Trading
At its core, futures trading refers to the buying and selling of contracts that obligate the buyer to purchase (or the seller to sell) an underlying asset at a predetermined future date and price. These contracts are standardized agreements that are traded on a futures exchange. They can be used to trade various assets, including commodities, currencies, stocks, bonds, and even intangible assets like interest rates.
The primary goal behind futures trading is to manage risk (hedging), speculate on price movements, or gain exposure to specific assets without directly owning them. It allows traders to lock in prices, gain leverage, and potentially profit from market fluctuations.
Components of a Futures Contract
Before diving into how futures trading works, it’s essential to understand the key components of a futures contract:
- Underlying Asset: The asset that the futures contract is based on, such as commodities (oil, gold, wheat), financial instruments (stocks, bonds), or indices.
- Contract Size: Futures contracts specify the amount of the underlying asset. For instance, one futures contract for crude oil might represent 1,000 barrels of oil.
- Settlement Date: The specified date on which the contract will be settled, either by physical delivery of the asset or through a cash settlement.
- Price: The agreed-upon price at which the underlying asset will be bought or sold at the time of the contract’s expiration.
- Margin: The initial deposit required by both buyers and sellers to enter a futures position. This ensures the ability to fulfill the contract.
Types of Futures Contracts
There are different types of futures contracts in the market. The two primary categories are:
Commodity Futures Contracts:
These involve physical goods such as oil, gold, agricultural products, and natural gas. Commodity futures are typically used by producers and consumers to lock in prices and hedge against price fluctuations.
Financial Futures Contracts:
These involve financial instruments such as stock indices, interest rates, and currencies. Financial futures are often used for hedging or speculating on movements in the financial markets.
How Does Futures Trading Work?
Futures trading involves buying and selling these contracts to either take delivery of the underlying asset at a future date or to liquidate the position before the contract expires. Here’s how the process typically works:
Buying a Futures Contract:
When a trader buys a futures contract, they agree to purchase the underlying asset at a specific price on a particular date. This is called a long position.
Selling a Futures Contract:
Conversely, when a trader sells a futures contract, they agree to deliver the underlying asset at the predetermined price and date. This is known as a short position.
Leverage in Futures Trading:
Futures contracts are typically traded on margin, which means you can control a large position with a relatively small amount of capital. This provides significant leverage, allowing traders to gain exposure to substantial amounts of an asset without needing to pay for the entire position upfront. However, leverage can amplify both profits and losses.
Hedging vs. Speculation:
- Hedging: Producers or consumers of a commodity may use futures contracts to protect against price fluctuations. For example, a wheat farmer might sell wheat futures contracts to lock in a price for their crop before harvesting.
- Speculation: Traders who engage in futures trading without the intent to take physical delivery of the underlying asset are often speculators. They aim to profit from price changes in the market.
Expiration and Settlement:
As futures contracts approach their expiration date, traders must either:
- Close their position: Traders can offset their futures position by buying/selling an opposite contract. For instance, if they hold a long position (buy contract), they can sell the same contract before expiration to avoid delivery.
- Take delivery: Although rare for speculators, some traders may choose to take delivery of the underlying asset if they hold the position until expiration.
Daily Mark-to-Market:
Futures contracts are subject to daily mark-to-market settlement, meaning that gains and losses are realized every day, and traders must maintain sufficient margin levels. If the value of the position declines, they may receive a margin call, requiring them to deposit additional funds.
Why Do People Trade Futures?
There are several reasons why individuals and institutions engage in futures trading:
- Hedging Against Price Volatility: Futures contracts offer a way to mitigate the risks of price fluctuations in commodities, currencies, or stock indices. For example, airlines might use futures to hedge against rising fuel prices.
- Speculating for Profit: Traders can use futures to speculate on the price movements of assets like oil, agricultural products, or financial instruments. By predicting whether the price will rise or fall, they can profit by taking a long or short position.
- Portfolio Diversification: Investors can use futures trading to diversify their portfolios by gaining exposure to different asset classes or markets.
- Leverage: Futures contracts allow traders to control a larger position with a relatively smaller amount of capital. This makes it an attractive option for traders looking to amplify potential returns, though it comes with higher risks.
Key Players in Futures Trading
Futures trading involves various market participants, including:
- Hedgers: These are individuals or businesses that use futures contracts to protect themselves from price fluctuations in the underlying asset. For example, a gold producer might use gold futures to lock in a selling price for future production.
- Speculators: Speculators aim to profit from price movements in futures markets. They do not intend to take delivery of the underlying asset. Instead, they buy low and sell high (or sell high and buy low) to earn profits from price fluctuations.
- Arbitrageurs: These traders look for price discrepancies between different markets or contracts and attempt to profit by exploiting these inefficiencies.
- Brokers and Exchanges: Futures contracts are traded on regulated exchanges, such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE). Brokers facilitate trading by matching buyers and sellers and providing access to the market.
What is futures trading?
Futures trading is the act of buying and selling futures. These are financial contracts in which two parties – one buyer and one seller – agree to exchange an underlying market for a fixed price at a future date. Futures give the buyer the obligation to buy the underlying market, and the seller the obligation to sell at or before the contract’s expiry.
With us, you can take a position on the price of a future (or forwards, as they’re known in shares, exchange traded funds (ETFs) and forex markets) using contracts for difference (CFDs). Many traders find this more accessible because you don’t have to take on the obligation to buy or sell, and you won’t be taking ownership of the underlying asset. Plus, there are possible tax benefits.
Why trade futures?
Avoid overnight funding charges
Many of our markets are available with futures (sometimes known as forwards) or spot (sometimes known as cash).
Futures positions have no overnight funding2 charges, whereas charges apply to spot (cash) positions that are left open at the end of a trading day. This means that futures trading is preferred by those who are looking to take a longer-term position on an underlying market – because they won’t incur multiple overnight funding fees.
Bear in mind, however, that futures do have a wider spread than spot (cash) positions.
Access our deep liquidity
The number of trades that we handle every day – coupled with our size, international reach and large client base – means that our futures markets are particularly liquid. This means that if you deal in larger sizes, you’re more likely to have your order filled at your desired price. Learn more about our best execution times and deep liquidity
Trade with leverage
Futures contracts are leveraged. That is, they enable you to receive increased market exposure for a small deposit – known as margin – and your trading provider loans you the rest of the full value of the trade.
When trading with leverage, it is important to remember that your profit or loss will be determined by the total size of your position, not just the margin used to open it. This means there is an inherent risk that you could make a loss (or a profit) that could far outweigh your initial capital outlay.
Go long or short
When trading futures, you can go both long or short. You’d go long if you believed that the underlying market price will rise, and you’d go short if you believed it will fall.
With our CFD futures, your profit or loss is determined by the accuracy of your prediction, and the overall size of the market movement.
Hedge your existing positions
Hedging with futures enables you to control your exposure to risk in an underlying market. For example, if you own shares in companies on the US Tech 100 and are concerned about their value dropping, you could short a US Tech 100 index future – the profits from which would hopefully offset a proportion of your share position losses.
If you had current short positions on the other hand, you could go long on an index future in case the market rises, with the idea that your long profits would offset your short losses.
Underlying Assets
Futures traders can lock in the price of the underlying asset. These contracts have expiration dates and set prices that are known upfront. Stock futures have specific expiration dates and are organized by month. The underlying assets in futures contracts may include:3
- Commodity futures with underlying commodities such as crude oil, natural gas, corn, and wheat
- Cryptocurrency futures are based on moves in assets like Bitcoin or Ethereum
- Currency futures, including those for the euro and the British pound
- Energy futures, with underlying assets that include crude oil, natural gas, gasoline, and heating oil
- Equities futures, which are based on stocks and groups of stocks traded in the market
- Interest rate futures, which speculate or hedge Treasurys and other bonds against future changes in interest rates
- Precious metal futures for gold and silver
- Stock index futures with underlying assets such as the S&P 500 Index
How Futures Trading Works
Futures contracts are standardized by quantity, quality, and asset delivery, making trading them on futures exchanges possible. They bind the buyer to purchasing and the other party to selling a stock or shares in an index at a previously fixed date and price.5 This ensures market transparency, enhances liquidity, and aids in accurate prices.
Stock futures have specific expiration dates and are organized by month. For example, futures for a major index like the S&P 500 might have contracts expiring in March, June, September, and December.6 The contract with the nearest expiration date is known as the “front-month” contract, which often has the most trading activity. As a contract nears expiration, traders who want to maintain a position typically roll over to the next available contract month. Short-term traders often work with front-month contracts, while long-term investors might look further out.1
When trading futures of the S&P 500 index, traders may buy a futures contract, agreeing to purchase shares in the index at a set price six months from now. If the index goes up, the value of the futures contract will increase, and they can sell the contract at a profit before the expiration date. Selling futures works the other way around. If traders believe a specific equity is due for a fall and sell a futures contract, and the market declines as expected, traders can buy back the contract at a lower price, profiting from the difference.
Speculation
A futures contract allows a trader to speculate on a commodity’s price. If a trader buys a futures contract and the price rises above the original contract price at expiration, there is a profit. However, the trader could also lose if the commodity’s price was lower than the purchase price specified in the futures contract. Before expiration, the futures contract—the long position—can be sold at the current price, closing the long position.
Investors can also take a short speculative position if they predict the price will fall. If the price declines, the trader will take an offsetting position to close the contract. The net difference would be settled at the expiration of the contract. An investor gains if the underlying asset’s price is below the contract price and loses if the current price is above the contract price.
Suppose a trader chooses a futures contract on the S&P 500. The index is 5,000 points, and the futures contract is for delivery in three months. Each contract is $50 times the index level, so one is worth $250k (5,000 points × $50). Without leverage, traders would need $250k. In futures trading, traders only need to post a margin, a fraction of the contract’s total value.7 If the initial margin is 10% of the contract’s value, the trader deposits only $25,000 (10% of $250,000) to enter the futures contract. If the index falls by 10% to 4,500 points, the value of the futures contract decreases to $225,000 (4500 points x $50). Traders face a loss of $25,000, which equals a 100% loss on the initial margin.
Hedging
Futures trading can hedge the price moves of the underlying assets.2 The goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Suppose a mutual fund manager oversees a portfolio valued at $100 million that tracks the S&P 500. Concerned about potential short-term market volatility, the fund manager hedges the portfolio against a possible market downturn using S&P 500 futures contracts.
Assume the S&P 500 is at 5,000 points and each S&P 500 futures contract is based on the index times a multiplier, say, $250 per index point. Since the portfolio mirrors the S&P 500, assume a hedge ratio of “one-to-one.” The value hedged by one futures contract would be 5,000 points × $250 = $1,250,000. To hedge a $100 million portfolio, the number of futures contracts needed is found by dividing the portfolio’s value by the value hedged per contract: $100,000,000 / $1,250,000 = about 80. Thus, selling 80 futures contracts should effectively hedge the portfolio with two possible outcomes.
Pros and Cons of Futures Trading
Futures trading comes with advantages and disadvantages. Futures trading usually involves leverage and the broker requires an initial margin, a small part of the contract value. The amount depends on the contract size, the creditworthiness of the investor, and the broker’s terms and conditions.
Futures contracts can be an essential tool for hedging against price volatility. Companies can plan their budgets and protect potential profits against adverse price changes. Futures contracts also have drawbacks. Investors risk losing more than the initial margin amount because of the leverage used in futures.
Pros
- Potential speculation gains
- Useful hedging features
- Favorable to trade
Cons
- Higher risk because of leverage
- Missing out on price moves when hedging
- Margin as a double-edged sword
Why Trade Futures Instead of Stocks?
Trading futures instead of stocks provides the advantage of high leverage, allowing investors to control assets with a small amount of capital. This entails higher risks. Additionally, futures markets are almost always open, offering flexibility to trade outside traditional market hours and respond quickly to global events.
Which Is More Profitable, Futures or Options?
The profitability of futures versus options depends largely on the investor’s strategy and risk tolerance. Futures tend to provide higher leverage and can be more profitable when predictions are correct, but they also carry higher risks. Options offer the safety of a nonbinding contract, limiting potential losses.
What Happens If Investors Hold a Futures Contract Until Expiration?
When equities are the underlying asset, traders who hold futures contracts until expiration settle their positions in cash. The trader will pay or receive a cash settlement depending on whether the underlying asset increased or decreased during the investment holding period. In some cases, however, futures contracts require physical delivery. In this scenario, the investor holding the contract until expiration would take delivery of the underlying asset.
Also Read : What Are The Most Effective Futures Trading Strategies?
Conclusion
Futures trading plays a crucial role in financial markets, allowing traders and businesses to hedge against price fluctuations, speculate on asset prices, and diversify their portfolios. By understanding how futures contracts work, the benefits and risks involved, and the key players in the market, traders can make informed decisions. However, it’s important to remember that trading futures requires significant expertise, discipline, and careful risk management.
FAQs
What is the difference between futures and options trading?
- Futures contracts obligate the buyer to buy or sell the underlying asset, while options give the buyer the right (but not the obligation) to buy or sell at a specific price before the expiration date. Futures contracts are more rigid, while options offer more flexibility.
How much capital do I need to start trading futures?
- The required capital varies depending on the contract size, margin requirements, and the asset being traded. Futures require an initial margin (a percentage of the total contract value), which can range from hundreds to thousands of dollars.
What are the risks of trading futures?
- Futures trading carries significant risks, especially due to leverage. A small price change can lead to substantial profits or losses. Traders must manage risk carefully and may face margin calls if the position moves against them.
Can I trade futures on a part-time basis?
- Yes, futures trading can be done on a part-time basis. However, it requires a solid understanding of the market, as well as the ability to monitor positions and make quick decisions.
Do I have to take physical delivery of the asset in a futures contract?
- Most futures traders do not intend to take physical delivery of the asset. Instead, they close out their positions before the contract expires. Delivery usually occurs only in specific situations where the trader holds the contract until expiration.
What factors affect futures prices?
- Several factors influence futures prices, including supply and demand, geopolitical events, economic reports, interest rates, and seasonal trends.
Are futures trading suitable for beginners?
- Futures trading can be complex and risky, making it unsuitable for absolute beginners. However, with proper education, risk management strategies, and practice, new traders can get involved in the market.
