What is Futures Trading?

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What is Futures Trading?

If you ever hear about fictional characters wheel and deal over futures, you must be familiar with the phrases “invest in pork bellies” or “corner the market”. The movie “Trading Places” by Eddy Murphy/Dan Akroyd climaxed over the price of a product most people forgot: frozen orange juice. How can anyone become wealthy on pre-bacon or concentrated Minute Maid? The answer is Futures, a market where traders can make unfathomable fortunes or massive debts.

What are Futures?

You can only understand the Futures market is you know the term “futures contract”. This refers to an investment product that thrives around the concept of the buying and selling of commodities at a future date. Futures contracts are a legally binding agreement to buy or sell merchandise at an agreed price on a specific time in the future.

The classic futures contracts dealt with commodities like unprocessed materials like pork bellies, gold, wheat, wood, or corn. Modern contracts deal with intangible assets like cryptocurrencies, indices and currencies.  Day traders love them because you can buy and re-sell futures contracts any time they are open to the fulfillment date.

Futures Market

A futures market is the platform where traders make futures contracts and a similar financial protocol called “options contract.” Options are similar to futures contracts only that parties can “forget” the contract if it’s unprofitable. Just like the stock exchange, the futures market hosts the clearinghouse and enables traders to conduct business. 

Futures markets may have started with agricultural products and mostly focus on commodities. However, today people trade anything that has a price on futures contracts. Nowadays, traders build futures contracts around foreign currencies, indices, cryptocurrencies, and anything else you can name. The only limiting factor would be finding a willing buyer or seller.

Futures VS Stocks

There are vast differences between trading futures and trading stocks. For instance, a stock gives you partial ownership of a company, and its value is reflected in the current pricing. A stock is considered a capital investment because you receive an ROI.

A future, on the other hand, derives its value from the commodity in question. You buy or sell a futures contract based on the anticipated price of the product. Where stocks are traded for market growth and dividend, commodity futures are traded on expected price action.

The Pros and Cons of Using Futures

When you trade futures, you avoid the risk factor associated with speculation. Futures contracts come with a specific expiry date agreed upon by both parties, after which the contract ceases to exist. The futures price changes every day, meaning the price difference is settled daily with the underlying assets mainly being commodities, stocks, currencies, interest rates, and bonds, etc. The deals are processed based on the predetermined price and according to contract terms.

Pros of Futures Trading

Risk Management: Futures trading is built around the concept of risk management. People who are afraid of trading in an uncertain market are not left out as they have futures contracts.

Fast Earning in Speculation: If you have good judgment, futures trading will enable you to earn quick money.

Efficiency and Fairness: Compared to other trading markets, traders find the futures market more efficient and fair in gains and losses.

Cons of Futures Trading

Leverage issues: The leverage offered in a futures contract can become a troublesome issue due to rapid price movements. Contract prices can pick up one day and fall the following day.

Timing issues: The future expiry date of these contracts is fixed. In most cases, the price becomes less attractive to other traders as the expiry date approaches.

This can cause a premature expiration of a futures contract.

Learn How to Trade Futures

Learning to trade futures well can place you smack in the middle of a profit center as a trader or speculator. Excellent trading skills will also help you hedge your portfolio and reduce potential losses. Like all speculative markets, futures trading isn’t for everyone, especially those who can’t take risks. If you want a fast-moving trade opportunity, futures is the way to go:

Understand the Risks

Leverage is an essential factor in futures trading because you can leverage up to 95% and only a small amount of your own money. Like all speculative markets, futures can be a profit center if you learned well or give you huge losses depending on your trading. Futures trading is not for you if you can’t take risks, but if you enjoy fast moving trading opportunities, you are home and dry.  Futures are based on margin trading, meaning if you are a speculator, you can participate in the futures market by using a small margin instead of the entire value of your physical holdings.

Choose Your Method

There are four different ways you can trade commodities on the futures market.

DIY Trading: Retail traders mostly use self-directed trading. You make your own decisions, execute your trades, and ultimately take responsibility for the outcomes.

Broker Managed Account: You can choose a dedicated licensed broker for a personalized and long term relationship.  The broker will help you in researching and monitoring markets and placing orders.

Managed Futures: If trading managed funds like index funds, mutual funds, choose a who makes all the decisions and allocates assets including rebalancing your portfolio

Automated and Algorithmic Systems: Choose a computerized system if you love futures trading but lack time to formulate, monitor, and implement your trading plan.

Choose a Futures Broker

Choosing a serious futures broker is an unviable task of carefully balancing a variety of requirements. Balancing between intuitive platforms, low commissions, excellent customer service, and up-to-date research options can be tricky. Avoid complicating a high-risk venture by using a broker where everything ticks like clockwork. Some of the factors to consider include:

Futures Expertise and Support: A good brokerage should have a reservoir of accessible training and educational materials. Training videos and articles can be a great source of information when you are just starting. 

Brokerage Fees: Whether you’re a DIY or broker-assisted trader, always choose a firm with transparent pricing and a good track record in the market. Remember that cheap can end up being expensive. Make sure that you get value for your money concerning customer support, expertise, and training.

State-of-the-art Option: Some brokerages have platforms that have incentivized social functionality. They can allow you to earn subscription fees by sharing your trade or other methods that will enable you to earn passive income when you share trade strategies. 

Choosing the right broker with an optimal platform is the difference between success and failure. Since this is doubly true for futures trading, carefully study top brokers like XTB, Trading212, Plus500, or AvaTrade. Considering the attributes outlined above helps to maximize your returns.

Choose Your Contracts

Some factors to consider when selecting a futures contract trade include:

Margin requirement: This refers to the amount of capital required; fund your futures trading account with 3 to 4 times the required margin

The spread: This is the difference between the bid and ask; spread determined what it costs to enter or exit a futures position.

Liquidity: Refers to the stability of interest traders have in buying and selling a contract. 

Increased stability tightens the spread due to high interest, while decreased stability means a loose spread from low interest. 

Daily volume consistency: Any scale of predictability gives an edge in futures trading. Inconsistencies and volume fluctuations above or below the average are an indicator of price movement.

Speculation and Hedging In Futures Contracts

Speculation and hedging are descriptive terms for two types of traders and investors in futures trading.

Speculators: They try to make a profit based on a security’s price change. The aim of speculating is to profit by betting on the direction an asset will take. Speculation is for risk lovers and is more vulnerable to market fluctuations.

Hedgers: Hedgers take an offsetting position in a derivative to balance gains and losses to the asset they’re trading. Hedging tries to remove volatility associated with prices by taking a position contrary to what the investor has set. Hedging is for risk-averse traders and works to eliminate risk or volatility associated with an asset’s price change.

Real-life examples of using futures

An oil producer can use futures contracts to lock in a price at which they will sell and deliver to a seller at the future contract’s expiry at a known rate. Simultaneously, a manufacturing company that needs oil can plan and have oil coming in monthly using several future contracts. The futures contract enables the manufacturer to plan as they already know the purchase price before delivery at the contract’s expiry.  

Concluding Thoughts

Futures contracts are a good investment alternative that’s not directly related to stock market prices. Commodity futures trading can enable you to access other asset class investments. Cryptocurrency, Forex, indices, and other forms of futures trading have benefits of low trading costs. However, be careful of risks associated with high market volatility. 

What is a futures contract?

It is a standradized agreement between a buyer and a seller on the trading floor of a futres exchange. It involves the buying and selling of a predetermined quality and quantity of a specific financial instrument or commodity.

What is a commodity?

A commodity in futres trading is the product or article of commerce that leads to a futres contract. The commodity can be anything and includes agricultural products, petroleum, metals, Forex, cryptocurrencies and indices etc.

What is a futures exchange?

A futres exchange is an association of people the partcipate in the business of buying and selling futures contracts or futures options. Futures exchanges are located all over the world.

How do I get started trading futures?

To get started trading futures, open an individual trading account in a futures exchange that offers the commodity of financial instrument you are interested in.

Why should I trade futures?

Futures trading is used for speculation, hedging and arbitrage.
In speculation you deal with expected changes in price levels without owning physical delivery. You speculate profit from futures trading and buy contracts at lower prices and hope to sell at a higher price.  
Arbitraging refers to a simultaneous buying and selling of the same commodity or instrument in different markets to make a profit form the price differences.

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