What is Futures Trading? - MagnifyMoney

What is Futures Trading?

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Futures trading is a form of asset exchange in which a buyer agrees to a future purchase of a particular asset at a predetermined price. Assets on the futures trading market include physical commodities (like oil or coffee futures) and financial products (like stock market futures).

Some futures traders are “hedgers” locking in the price of an asset they need, while others are “speculators” betting on an asset’s price movement so they can make a profit. Futures trading with the goal of making money is a risky but potentially quite profitable way to trade.

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How the futures market works

Futures trading happens on futures exchanges, which are regulated by the Commodity Futures Trading Commission (CFTC). The CME Group operates the largest U.S. derivatives exchange in terms of trading volume — one of the exchanges listed by the CME Group is the Chicago Board of Trade, which started in 1848 and was the first grain futures exchange in the country. Exchanges like the CME Group standardize futures contracts and set the parameters for trades.

Some brokerages have futures trading hours for virtually 24 hours a day, so futures markets are changing almost constantly. Some traders buy and sell futures very quickly: They could theoretically speculate on a stock price after the day’s normal trading window closes and then close their position before the market opens the next day.

What is a futures contract?

Futures trading is done through futures contracts. A futures contract is the agreement two parties make to sell and buy a specific quantity of an asset at a certain price and the date in which the asset is to be traded. A futures contract is a derivative financial product: Its value depends on the value of the underlying asset. Futures contracts are priced through the futures exchange.

Corporations often complete orders of raw materials through the futures exchange. If the futures contract is for a physical product like beef, the futures contract will often include another parameter for product quality (such as the grade of beef).

Futures contracts mandate that the asset must be delivered when they expire. For financial instruments, futures contracts can sometimes be settled in cash — or the stock, bond or other asset could be transferred from seller to buyer at the expiration date. For physical commodities, the buyer is responsible for the transportation and storage of the commodity when the contract expires.

Buyers often choose to purchase futures contracts on margin, meaning that the brokers who place their trades only require a small fraction of the total value of the futures contract up front. By trading futures on margin, the stakes are raised: A buyer can be leveraged into a situation where their potential losses significantly exceed the cost of their initial purchase. In those situations, the broker places a “margin call” requiring additional funds to cover the losses. However, on the other hand, trading on margin can lead to huge windfalls; just like losses can be magnified, gains can be as well.

Common types of futures contracts

There are several different kinds of futures contracts. Commodities are often traded as futures, but financial derivatives are common on the futures market as well. For the most part, if an asset class is bought and sold on the market, it can be bought and sold as a futures contract as well.

  • Commodity futures: Three main categories of commodities futures are agriculture (including livestock and crops), energy (mostly related to oil and gas) and metals (both precious metals like gold and materials like copper). These commodities futures may be more of interest to companies that use or produce raw materials, but the futures market provides access to speculators who are otherwise unable to trade those commodities.
  • Stock futures: Stocks and index funds are often traded on futures exchanges, allowing people to speculate on future price swings. Index fund futures typically have high contract sizes, so many retail traders may not be able to access the futures market for big index funds. However, stock futures might be more accessible to the average investor and could be a good introduction to the futures market. Popular stock market futures include index funds like Dow futures and S&P 500 futures.
  • Bond futures: Much like stocks, U.S. Treasury bonds can be traded as futures. Investors tend to maintain a portfolio that’s balanced with stocks and bonds, and much like normal bond trading, bond futures purchases can be hedged against unfavorable market changes.
  • Currency futures: The foreign exchange (forex) futures exchange is another place where speculators can bet on the future price fluctuation of foreign currencies.

Why would someone trade futures?

Some people sell futures to mitigate the potential risk of a future price fluctuation, while others do so to ensure that their commodity will net a future profit. Companies often enter commodity futures contracts to complete orders of raw materials months in advance. For example, suppose that an agribusiness decides to sell a futures contract when they plant their corn in March. They’ll agree to a quantity of corn (say 100,000 bushels) at a price ($5 per bushel) and deliver the commodity to the buyer at a given date (in November). They know that their total cost of producing that corn is less than the total $500,000 value of the contract, so they ensure that their corn will net a profit.

That buyer might be a speculator who may not intend to receive and store 100,000 bushels of corn. Instead, if they think that the price of corn will rise over the span of the contract, they could close out their position by selling the contract in July at the price of $6 a bushel, netting them a profit of $1 per bushel, or $100,000 total. Since the speculator usually trades on margin and might only have to put up a small percentage of the value of the original contract — maybe only 5% (or $25,000, in this example) — that futures speculation could lead to a huge profit.

Of course, the buyer carries some risk in this example. Suppose that the price of corn falls instead of rises, and that the price per bushel in July is $4. The buyer would have to decide to hold the contract (and risk a further price drop) or close their position. The broker would likely place a margin call requiring the buyer to provide additional money to cover the potential loss on the contract. If the price of the asset is lower when the futures contract is closed, they’d be on the hook for the net loss on the speculation. If the buyer sells their corn futures when the price is $4 per barrel, they’d suffer a $100,000 loss.

Hedgers vs. speculators

Instead of speculating, many buyers and sellers are hedging against unfavorable price movements with futures contracts. The corn supplier in the example above is hedging against a future drop in the price of corn: They might lose out on potential further profit if corn is more expensive in November than when they sold the contract in March, but they’re ensuring that they’re protected against falling prices.

Likewise, active traders may choose to purchase stock market futures to hedge against market volatility in the short run by using their ability to trade on margin to leverage themselves into a favorable position. If they think that there could be market turbulence in the near future but that the market will eventually recover, they could purchase futures contracts.

Pros and cons of futures trading

Significant profit potential for speculators who trade on marginSignificant loss potential for speculators who trade on margin
Buyers can hedge against asset price downturnsLiquidity limitations and settlement risks for buyers
Provides access to commodities market for speculationFutures markets can be volatile, especially for commodities

Risks of futures trading

Just as futures trading holds the potential for great financial rewards, it can also cause great financial losses. The heightened stakes of trading on margin and the volatility in commodity prices can pose serious risks for traders.

Price speculation

An obvious source of risk for buyers in the futures market is that prices could fall instead of rise. If you were to purchase shares of company stock for $100 a share as part of a futures contract and the company’s stock price falls to $75 a share, you could incur serious losses if you close your position. There’s no guarantee that the underlying assets in the futures contract will hold their value, and if they lose value, you’re out of luck.

Trading on margin

Buying futures contracts on margin means that the buyer has to put up only a small fraction of the contract’s worth at the time of the purchase. If you’re buying 100 shares of stock at $100 apiece, the total value of the contract would be $10,000 — but you may only have to pay 5% ($500) yourself to execute the trade.

If the asset price falls enough, the brokerage will make a margin call and require you to deposit additional funds to cover the likelihood of a loss. Different brokerages have different rules for making margin calls, but brokers typically give investors a few days to meet the call. Let’s say you close out your position at $75 a share (meaning the stock is worth $7,500) — you’d be required to cover the full $2,500 loss, even if you had to put up only $500 when you opened the futures contract.

How to trade futures

There are some steps you should take if you decide to enter the competitive, high-stakes world of futures trading.

  1. Do your research: Any trading should be informed by solid market research. Some investors prefer fundamental analysis, in which they focus on the intrinsic value of an asset, while others prefer technical analysis, in which they look at statistical trends across the broader market.
  2. Determine your futures trading strategies: Once you’ve researched enough information regarding the asset classes you’d like to trade on the futures market, choose which investments you’d like to pursue, decide how to position your hedging approach and plan on how you intend to close your positions.
  3. Find a futures trading platform: Several brokerage firms offer investors the ability to trade futures contracts on their platforms, including TD Ameritrade, Charles Schwab and E*Trade.
  4. Execute your futures trades: When making your trade, you’ll need to agree to the price and quantity of the asset you intend to buy, as well as a date when the trade will be settled — those variables are determined by the market and futures exchanges. You’ll also agree to a margin requirement and put up the required capital to make the trade.
  5. Monitor the asset price: In order to know if your bet is paying off or not, you’ll have to closely monitor the asset price. Unlike the traditional equities market, the futures market operates nearly 24/7, so you’ll need to keep an eye on the value of your futures contracts, especially for more volatile assets. If there’s a downturn in price, you’ll find out if you might need to make a margin call.
  6. Close your position: You’ll decide to close your position by either selling the futures contract or letting the terms of the trade settle at the expiration date. If you close your position at a loss, you may need to pay the broker to cover the cost of the trades.

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