Futures contracts allow the purchase or sale of a commodity or financial instrument at a predetermined price on a future date. They are popular with commodity producers and purchasers looking to hedge risk and speculators seeking to profit from favorable price movements.
This comprehensive guide covers everything you need to know about trading futures, including:
- What futures are and how they work
- Using futures for hedging and speculation
- Different types of futures contracts
- The risks and rewards of futures trading
- Getting started trading futures
- Frequently asked questions
Whether you’re an investor looking to expand your portfolio or a business seeking to manage commodity price risks, read on to learn if futures trading has a place in your financial plans.
What Are Futures Contracts?
A futures contract is an agreement to buy or sell an asset at a predetermined price on a specified future date. One party takes a long position agreeing to purchase the asset while the other party takes a short position agreeing to sell it.
For example, a December 2025 gold futures contract obligates the buyer to purchase gold and the seller to sell it at a set price on or before December 2025, regardless of the current market price.
Futures trade on centralized commodities exchanges like the Chicago Mercantile Exchange (CME) and are standardized agreements facilitated by a clearinghouse. Standardized specifications make it easy to offset positions before expiration since traders take the opposite side of equivalent contracts.
Some key features of futures contracts:
- They trade on margin, requiring only a percentage of the full value upfront
- Gains and losses are settled daily via margin accounts
- Prices fluctuate according to supply/demand dynamics until expiration
- Long/short positions can be held indefinitely or offset before expiry
Participants trade futures to speculate, hedge, or gain exposure to commodities, indexes, interest rates, and global currencies.
Using Futures Contracts to Hedge Risks
Hedging with futures involves opposing an existing exposure to protect against potential adverse price movements.
For example, an airline might buy oil futures to lock in fuel costs and offset losses if prices rise. A farmer could sell crop futures to guarantee a selling price, protecting against falling market prices at harvest time.
The key objective of hedging is mitigating losses in exchange for capping profits if the market moves favorably. Hedgers give up some upside potential to limit downside risks to their business operations.
Speculating with Futures
Conversely, speculators aim to profit from correctly predicting future price trends with no intention of handling the physical commodities.
A speculator might buy soybean meal futures expecting rising demand from the livestock industry will drive up prices. If correct, they sell the contracts later at a higher price to cash in on the price appreciation.
The high leverage afforded by margins amplifies potential profits and losses, making futures popular for speculation. A 10% price move results in exponential returns given the fractional margin requirements.
However, leverage cuts both ways. Significant losses can mount rapidly with an adverse price move, forcing additional margin deposits to maintain positions. Risk management using stop orders is key to avoid exceeding loss limits.
Different Types of Futures Contracts
Myriad futures trade on exchanges today on underlying assets like:
- Commodities – crude oil, natural gas, corn, wheat, coffee, sugar, lumber
- Currencies – euro, pound sterling, Japanese yen, Indian rupee
- Indexes – S&P 500, Nasdaq 100, Nikkei 225, FTSE 100
- Interest Rates – U.S. Treasuries, Eurodollars, Eurobonds
- Metals – gold, silver, platinum, copper
Standardization by clearinghouses makes offsetting open futures positions easy. For example, buying back identical corn contracts eliminates existing commitments.
Some futures, like stock indexes and interest rates, settle in cash. Commodity futures may involve physical delivery but often roll to later expiries to avoid it.
Either way, ongoing price discovery based on supply/demand dynamics continues up to and during delivery dates. Both hedgers and speculators close most positions before expiration to realize profits/losses and avoid handling physical goods.
Risk and Reward Profile of Futures
Before jumping into futures trading, weigh the following pros and cons:
Benefits
- Magnify returns through embedded leverage
- Hedge business risks like commodity prices, foreign exchange, interest rates
- Speculate on market moves either higher or lower
- Gain exposure to asset classes like commodities and global bonds
- Low-margin deposits keep capital requirements modest
The ability to control substantial contract values by owning little upfront can accelerate portfolio gains rapidly. Hedgers transfer unwanted risks at minimal cost to speculators seeking profit opportunities.
Drawbacks
- Leverage amplifies losses if prices move adversely
- Forced liquidations are likely if unable to meet margin calls
- Physical delivery can require extensive logistics/infrastructure
- Complex tax treatment for gains/losses relative to capital assets
Leverage giveth but also taketh away. Margin calls may force premature selling at losses when additional margin can’t be funded. Tax reporting involves extra paperwork as 60% of gains taxed at lower long-term rates.
READ ALSO: Commodity Investment Basics: What Beginners Need to Know for 2024
Getting Started Trading Futures
Investors looking to add futures usually start by trading options first or paper trading simulated accounts. But here are some tips for diving into actual futures trading:
Open a Futures Account
Brokers like E*Trade, TD Ameritrade, and NinjaTrader connect individual traders to major futures exchanges. Account minimums exist but can be low for certain products. Applications assess investing knowledge and trading experience to approve futures options trading privileges.
Research Contract Specifications
Each futures product has unique specifications for contract size, tick size, margin requirements, trading hours, settlement procedures, and delivery months to master. Study these details to match trades to objectives.
Develop a Trading Plan
The volatile futures markets demand adherence to a trading plan accounting for risk tolerances, position sizing, margin requirements, and tax considerations. Set profit targets and stop losses for trades before entering positions.
Start Small
Don’t overextend buying multiple contracts without experience. Begin trading one e-mini contract with reasonable margin reserved to avoid forced liquidations or added risk to cover margin calls. Adding contract size can accelerate as skills improve.
Frequently Asked Questions
Get answers to some common futures trading questions:
What’s the difference between futures and options?
Futures buyers must purchase the asset while options buyers can choose not to exercise their right to buy/sell. Futures sellers must deliver the asset if assigned where options sellers may not be assigned an exercise.
Are futures riskier than stocks?
Yes, the leverage compounds both gains and losses significantly. However, stop orders and disciplined risk controls can manage the heightened risks.
What do I do if I don’t want to take delivery of the commodity?
Close out futures positions before expiration because delivery procedures are complex. Some futures settle in cash eliminating delivery altogether.
What skills are needed to trade futures?
Success requires an understanding of margins, contract specifications, order types, tax implications, and risks like volatility, liquidity gaps, and leverage. An analytical personality suited to data analysis has advantages.
How much money do I need to trade a futures contract?
Required minimum capital varies based on the margin requirements of particular futures contracts. But most futures can be traded with an account balance between $2,500 and $10,000 to start.
The Final Word on Futures Trading
Futures markets facilitate the transfer of commodity price exposure between hedgers and speculators seeking opportunities from price changes over time. Leveraging via margins can rapidly multiply small initial investments.
But beware of the double-edged sword. Just as leverage boosts gains on the way up, it also accelerates losses on the way down. Always utilize stop orders and maintain enough margin to weather normal volatility.
While futures may seem complex at first, their standardized nature increases transparency in pricing and clearing once you grasp the basics. Developing competent trading skills takes time and practice, but the sizable profit potential makes the efforts worthwhile.
Start conservatively, build your future knowledge steadily, and reinvest early winnings wisely. Maintaining modest but consistent positive returns over time leads to accumulating substantial wealth. With the right foundation, futures offer a lifetime of financial opportunity.
In another related article, A Comprehensive Guide to Derivatives Trading and Investing
