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- Futures contracts allow traders to speculate on the direction of price movements on asset classes such as livestock, oil, and soybeans.
- Investing in futures can provide an additional layer of diversification to a portfolio.
- Futures are more complex and carry more risks than trading stocks or ETFs because of low margin requirements and volatility.
Futures trading involves buying and selling derivatives contracts for the purpose of speculation (attempting to generate a return based on predictions of future asset values) or hedging (taking steps to manage the risk tied to one's portfolio).
Investors who are interested in learning more about these possibilities can benefit from reading this article, which can help educate them on futures trading for beginners.
Futures are contracts where two parties agree to exchange a specific quantity of a commodity or other underlying asset for a predetermined price at a future time. These contracts were initially created to help businesses navigate unexpected costs.
For example, profits in the airline industry can be heavily dependent on the price of fuel. To protect against a sudden surge in prices, an airline company can use a futures contract to lock in current prices, thus nullifying the impact of increasing fuel prices. Futures contracts can be settled in cash or with physical goods. For traders, the settlement is in cash, while some businesses may opt for physical delivery.
Defining futures contracts
An agreement to buy/sell an asset at a set date and price
Putting this more simply, a futures contract is a legal agreement that obligates two parties to buy or sell an underlying asset for a predetermined price at an agreed-upon time.
This aspect differentiates futures from options, since an options contract gives the holder the right, but not the obligation, to purchase an underlying asset at a set price during a predetermined time frame.
Assets include commodities, currencies, etc.
There are many types of futures contracts, which derive their value from various asset types. The most common kinds are commodities like wheat, corn, and crude oil. Other asset types include precious metals, currencies, US Treasuries and funds that grant exposure to major stock indexes like the S&P 500.
Given the complex nature of these contracts, investors who want to learn how to trade futures successfully might benefit significantly from focusing on specific types.
Below are the most common categories.
- Precious metals: Gold and silver are the most common metals in this category. Investors who choose these types of futures contracts are generally looking to hedge against inflation or financial uncertainty but precious metals can also be used for more practical applications like platinum for semiconductor chips.
- Stock index: These contracts derive their value from a stock index like the S&P 500, Nasdaq, or Dow Jones Industrial Average. Investors try to use these types of futures to profit from anticipated movements or announcements from the Federal Reserve.
- Energy: Futures contracts that are based on energy would include oil and natural gas. These contracts can also serve as a benchmark for oil prices worldwide.
- Agriculture: Agriculture contracts are usually based on commodities like soybeans, corn and wheat. These contracts are a bit more unique due to the fact that weather patterns and seasonality play a much bigger role in impacting prices and risk.
- US Treasury/interest rates: Futures contracts based on interest rates and Treasury bonds play a significant role in international financial markets. Investors in this category closely watch the moves of the Federal Reserve.
- Livestock: Traders can even speculate on the prices of livestock like cattle and hogs. Price movements here are subject to consumer tastes and supply and demand pressure in addition to standard risks associated with futures.
Traded on futures exchanges
While some derivatives trade over-the-counter, futures contracts trade on exchanges, which means that they are, for the most part, standardized. In other words, they need to meet specific requirements, which includes clarifying the underlying asset, the settlement date (when the goods in question are delivered) and the settlement price.
Investors can trade futures contracts on many different exchanges, for example the Chicago Board of Trade (also known as CBOT) and the New York Mercantile Exchange (also known as NYMEX).
Why trade futures?
Speculation on price movements
Investors can trade futures to speculate on, and potentially profit from, changes in the value of a wide range of underlying assets, including commodities, stocks, and bonds. Because interested parties can harness futures to speculate on the future prices of so many different assets, futures contracts can be used to help construct a highly diversified portfolio.
Another draw of futures trading is that interested parties can buy and sell these contracts at almost all times of the day. Instead of 9:30 a.m. to 4 p.m. ET, the futures market is open nearly 24 hours a day, six days a week.
Hedging against price risk
Traders can use futures contracts to hedge risk in their portfolio. They can use these derivatives to hedge the risk that a component of their portfolio will fall in value. They can accomplish this by employing a short hedge strategy, which is something an investor can do if they think that the value of an underlying asset will fall over time.
The opposite would be a long hedge strategy, which is something that an investor can use if they think that an asset will rise in value over time. An organization like an automaker could potentially use this if they believe that the value of a key manufacturing component, for example steel, will increase in the near future.
Leverage (using a small amount of capital to control larger contracts)
One more aspect of futures trading that might attract interested parties is the fact that these contracts make use of leverage, which can potentially amplify returns. However, investors should keep in mind that harnessing leverage can also increase potential losses.
Margin is the practice of borrowing money from your brokerage to invest. Current margin requirements for futures contracts are between 3% and 12%. This means an investor could spend $5,000 of their own money to control a $100,000 position, which represents only a 5% stake in the aforementioned position. If this trade goes in the favor of the investor, there would be a significant windfall. But a negative move could result in serious losses. Before using debt to enter a trade, it is wise to carefully consider your risk tolerance.
Another draw is that some futures trades may qualify for preferential tax rates. "Typically, gains from short-term stock trades are taxed as ordinary income. However, gains from futures contracts are taxed at a 60/40 rate which is 60% long-term and 40% short-term. Currently long-term capital gains tax rates range from 0-20% depending on your federal income tax bracket," says Moswen James, an enrolled agent at Get Help Tax.
Risks of futures trading
High volatility and leverage can magnify losses
While futures trading can help traders generate substantial returns, it can also create significant losses.
One of the largest risk factors with futures is related to the margin requirements and price sensitivity. "Futures contracts are inherently very leveraged because the underlying valuation is very sensitive to the amount of funds invested as margin or collateral," says Chester Spatt, professor of finance at Carnegie Mellon University's Tepper School of Business.
Market complexity
There are several factors that contribute to the complexity of the futures market, including the use of leverage and expiration dates. Because these contracts make use of margin, investors can easily become overleveraged, which can potentially lead to significant losses and/or substantial volatility in one's portfolio.
Another consideration is that if an investor trades multiple futures contracts, it can be difficult for them to monitor their respective expiry dates. As these contracts approach these dates, their value can change sharply, potentially losing their worth.
Before getting involved with any futures contract, investors should figure out an entry strategy (how they will enter the contract) and also an exit strategy (how they will close out a trade).
Futures Trading FAQs
Futures and stock trading have certain things in common, but the former has additional considerations like leverage and also expiry dates.
Open an account with a broker that offers futures trading. This kind of trading can be very complex, so it is wise to conduct substantial due diligence before getting involved. It might be a good idea to spend a few months taking part in so-called paper trading so you can test out your strategy without putting money at risk.
Futures trading comes with significant potential for gains, but it can also generate substantial losses for those who take part.
Futures trading may not be the best place for beginners, seeing as how it is inherently complex and comes with significant risk.
Comex gold futures and crude oil futures are some examples of futures contracts.
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