How Futures Trading Works: Growing Your Investments

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Updated on Friday, April 10, 2020

Futures trading is a fast-paced market where investors, speculators and companies agree to buy and sell assets at some point in the future. The profit potential is high but so are the risks — especially if you don’t know what you’re doing.

While futures trading can offer large potential gains and be a great way to invest directly in assets like commodities, currencies and metals, it also requires a lot of research to compete against seasoned investors in the space and can lead to large losses. Before adding them to your portfolio, it’s important to fully understand how futures work.

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What is a futures contract?

A futures contract is an agreement between two parties: a buyer and a seller. The contract lays out that, at a set deadline in the future, the buyer will purchase some type of asset at an agreed-upon price and the seller agrees to sell.

Let’s say an airline is worried about the price of oil going up. They could enter into a futures contract with an oil company that agrees to sell them 10,000 barrels in May at $55 each. This way the airline doesn’t have to worry about prices going up and the oil company doesn’t have to worry about prices going down.

While futures contracts can involve the actual delivery of a physical good, like in the example above, they don’t have to. Instead, investors can buy and sell contracts without ever handling the underlying asset. For example, two investors could enter a futures contract for oil in which one investor agrees to buy 1,000 barrels at $55 and the other investor agrees to sell.

Before the contract matures, each investor can get out of their position by buying another contract that offsets their original purchase, so the buyer will then purchase a contract to sell 1,000 barrels and the seller will buy a contract to buy oil. This cancels out their positions so they never have to transfer any oil.

In this futures contract, the buyer makes money when the market price ends up above $55; if it goes below $55, the seller makes money. If the buyer decides to close their position when oil is at $58, they would make a $3,000 profit ($58-$55 x 1,000 barrels). The seller, on the other hand, would lose this amount.

Should I trade futures?

If  you’re wondering whether you stand a chance at success in trading futures, it’s first important to determine whether you really are a good fit for this type of investment.

Why to trade futures

Some of the reasons to consider trading futures include:

  • Access to commodities, currencies, metals and other assets: Futures contracts let you invest directly in the value of these assets. For example, you can buy a contract on the price of copper rather than just investing in the stock of a company that mines copper.
  • Ability to make trading decisions constantly, not just during business hours: Unlike U.S. stock markets, where trading primarily takes place during business hours, you can trade futures any time an exchange is open, which is 24/7 during the workweek.
  • Easy to take sell positions: Futures contracts are a convenient way to bet that the price of an asset will drop.
  • Large potential gains from leverage: With leverage, you can turn small price changes into much larger gains.

Why to avoid futures

Trading futures is not for everyone though. Some reasons to be cautious about entering this market include:

  • Margin calls require cash: Price swings are common in the commodities market. Even if your long-term prediction is accurate, prices might go against you in the short-term, which means you’d need to deposit more money for a margin call or you’d have to close out your position.
  • Leverage can lead to large losses: Leverage is great when your investments work but can be a disaster if you bet wrong.
  • A lot of research required: If you’re going to invest in futures contracts, especially using leverage, make sure that you know what you’re doing. You’re competing against lots of tough investors, including Wall Street pros.
  • May involve active trading: The downside of a near 24/7 market is that it means keeping up with information from around the world. Because of the frequent opportunity to trade, commissions can also significantly eat into investors’ returns. Brokers often charge a fee per trade, which can quickly add up the more trades you make.

How does trading futures work?

There are many different futures markets in the United States and around the world. They differ based on the types of assets listed on each exchange, when they are open and the amount of activity. Some of the major U.S. futures exchanges include the Chicago Mercantile Exchange, the Minneapolis Grain Exchange and the Nasdaq Futures, Inc. Globally, you can find futures markets in most large financial hubs like the Tokyo Financial Exchange in Japan or the European Energy Exchange in Germany.

In the past, traders physically went to these markets to buy and sell futures contracts. Some still do and make trades in a verbal auction. But now, you can access most of these markets electronically, from anywhere in the world.

Like with other investments, you can only buy or sell a futures contract when the market you trade on is open. That being said, futures contracts give you more flexibility to trade outside of normal business hours because you aren’t restricted to the U.S. futures market. This means you can make these buy or sell transactions anytime a futures market is open somewhere in the world. During the workweek, you can trade 24/7 because when you look around the globe, at least one market should be open at any point.

Futures trading strategies: Hedging vs. speculation

Investors use futures contracts for two common strategies: hedging and speculating. With hedging, an investor is trying to protect themselves from a price change. It’s like buying insurance. For example, the airline mentioned above was using a futures contract to hedge against losses from the price of oil going up.

In a hedging strategy, the investor usually takes two opposite positions to limit their potential losses. For example, an investor owns stock in a company but is worried about the price falling over the next few weeks. They could sell a futures contract on the same stock. If the investor was wrong and the price goes up, they miss out on that profit but if the price does drop, they protect their portfolio against a large loss.

With speculating, an investor aims to profit off of price changes. They try to predict the future price of an asset and then enter in a position that would make money off the change. So, if they think the price of oil will rise, they might buy a futures contract. The speculator usually just bets on one direction, either the price going up or down, so they can make a larger profit. In exchange, the risk is higher because they’ll lose more for being wrong.

Margin and leverage with futures trading

Margin is another key part of futures trading. Let’s say you enter a futures contract to buy 10,000 bushels of corn at $3.70 in June. In theory, that’s a $37,000 deal. But if you’re going to offset that contract before it expires, your loss or gain will be a fraction of the amount.

As a result, the investment broker will only require you to put down a fraction of your trade at first, like $2,000. This is called the initial margin. They will also set a minimum account value to keep the contract active.

If the price of corn starts to go down, making it more likely you will lose money in the future, the value of your futures position will also go down. Once you go past the minimum value, the exchange will give you a margin call, asking you to deposit more money to make up the difference. If you don’t, they could reduce your investment or even close out your entire position at that time.

Since you don’t need to put down the entire value of a contract, you can use leverage for your trades, meaning you can make larger investments on a small deposit. If an exchange gives you 10x leverage, a $1 price gain actually earns you $10. However, the risk is higher because small losses become much larger.

Futures trading and liquidity

When you enter into a futures trading contract, you don’t have to stay until the very end of the agreement. You can exit your position by trading with another investor. In other words, futures contracts are a liquid asset because you can turn your current investment into cash.

That being said, some futures markets are more liquid than others, depending on demand for the asset. In addition, you aren’t guaranteed to get all of your money back, especially if the market is going against your position.

Types of futures contracts

With the basics in mind, let’s look at a few of the most common types of futures.

Commodity futures

Commodities were the first type of futures contracts, and they deal with physical goods. Farmers originally used commodity futures to get price guarantees for selling their goods, but now they are also available as an investment.

There are all kinds of commodity futures including:

  • Grains (corn, soybean, rice)
  • Softs (coffee, orange juice, sugar)
  • Livestock (cattle, pork belly, lean hog)
  • Energy (oil, coal, propane, electricity)
  • Metals (gold, silver, copper, platinum)

Equity futures

You can also set up a futures contract based on shares of a certain stock (equity). The stock futures contract will lay out how many shares you’d buy or sell in the future, the contract closing date and the agreed-upon price.

This is similar to an options contract, where the investor buying the contract has the choice to buy a stock at a certain price from the seller of the option. But one key difference is that the futures stock contract locks in an agreement on both sides: The buyer must buy at the contract end date, either from the seller or by purchasing an offsetting equity futures contract.

Bond futures

With bond futures, you’re agreeing to buy or sell a certain bond by the contract end date, such as bonds issued by a government or by a company.

Index futures

Rather than setting up a contract on one stock or bond, you can use index futures to make investments based on an entire market. S&P futures set an agreement using index funds that track the S&P 500, while DJIA futures (also known as Dow futures) use funds that track the Dow Jones Industrial Average.

In these contracts, you pick which index fund you’d trade, the number of fund shares you’d buy or sell, the future price and the contract end date.

Currency futures

Currency futures are one more major market. With currency futures, you can lock in future agreements on a currency exchange rate. For example, let’s say a euro is currently exchanging at $1.118 USD. Someone might buy a contract to purchase euros at $1.125 for May.

Not only is this useful for investing, but it can also help companies lock in terms for an upcoming international deal.

How to trade futures

If you decide that futures trading is a good fit for your portfolio, here’s how to get started:

1. Choose a futures trading platform

First, you need to find a broker to start making trades. Many discount brokers offer futures trading — including the larger full-service brokers — but more specialized futures brokers also are available. InteractiveBrokers, for example, offers a tiered pricing structure in which broker commissions decrease depending on trade volume. Generic Trade, another low-cost online broker, has a flat fee structure that charges much lower commissions in comparison to some bigger brand names.

Brokers will have different rules for the minimum amount you need to open an account, the margin you’d need to put up for a trade, fees involved and the support offered to investors. Be sure to check each of these factors carefully as you decide where to open an account.

2. Develop a futures trading strategy

Before you start putting money into futures contracts, you need to develop your investment strategy. A key part of making successful trades is predicting the future value of the underlying assets. To do so, traders often use two main underlying strategies: fundamental and technical analysis.

Fundamental analysis looks at the broad economic and global factors to try and find pricing inefficiencies in the market. For example, this could be predicting a glut in oil production that will cause future prices to fall. Technical analysis looks at trading and pricing patterns — not the economic data — to find trends.

When you sign up for an online broker, they may also offer market research, trade ideas and other support tools for trading futures. There are also online courses, videos and books that can give you a more in-depth analysis of possible futures trading strategies. Finally, you could contact a financial advisor to see what they would recommend for your portfolio. With the help of these resources, you can develop a profitable futures trading strategy and get started.

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