What Are Futures?
Investopedia defines futures as a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures.
What is Futures Trading?
Futures trading is the trading of futures contracts. Futures contracts are unlike stocks. They have expiration dates. So what does that mean? Well it could mean that you own a bunch of corn or oil or whatever futures contract you had. Most people sell before the contract expires. If my order was placed through a broker it is almost impossible for a trader to accidentally hold the contract past its First day notice. If the broker cant contact the trader they will sell the position. So when you trade futures you are trading contracts.
Who can trade futures?
Anyone who has enough money can trade futures and the requirements are not as high as some may think. There are two basic categories of futures traders, hedgers and speculators.
Hedgers- Hedgers use futures to offset cost of doing business. For example the airline industry sells their tickets in advance. They may want to buy oil or fuel futures contracts. This would offset the cost of fuel if gas skyrockets. Futures can be a way to stabilize business costs in market changes.
Speculators- Speculators are the second major group of futures players. These participants include independent floor traders and investors. Independent floor traders, also called “locals”, trade for their own accounts. Floor brokers handle trades for their personal clients or brokerage firms. An online trader would be considered a speculator.
Should I trade Futures?
The futures market can be very stressful if you don’t have a good trading plan. The futures market closes for a short time everyday. Futures are available for trade throughout the night. That can be good if you have a job and want to trade at night. The problem is you need to sleep. I heard of a guy who fell asleep at his keyboard at night and lost a big sum of money. Obviously they would be no way to live. If you have a good system and set your stops at night before you go to bed then you can sleep at night.
Trading futures is not for everyone you need an account with at least 50k in it.
How much Risk is in Futures?
Futures are highly leveraged investments. The trader puts up a small fraction of the value of the underlying contract (usually 10%-15% and sometimes less) as margin, yet he can ride on the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contract, but a performance bond.
The actual value of the contract is only exchanged on those rare occasions when delivery takes place. (Compare this to the stock investor who generally has to put up at least 50% of the value of his stocks.) Moreover the commodity futures investor is not charged interest on the difference between the margin and the full contract value.
So for example lets say you buy a contract of oil. Currently a crude oil contract is for 1000 barrels of oil. The price of the March 2015 contract right now is $45. So the total value of 1 oil contract is $45,000. To trade one contract of oil you need $6364 in your account. So if your position goes down 10% then you would lose $4500. If it goes up 10% then you would gain $4500.
A Safer Way to trade
Trading Futures can be very dangerous as you see from the example above. With a good trading system you can see that if you only have $6364 in your account then you have no business trading a contract that is $45000 in value. Trading futures can be a very profitable way to trade but you need a proven and tested system.
There is much more that we could talk about with futures and we may come back to this topic at some point in the future.