Whether you want to hedge your portfolio to reduce risk or simply want to speculate on the price changes of particular asset classes, learning how to trade futures can be a great way to optimize your investment strategy.
In this guide, we’ll cover what futures are and how they work. We’ll show you how to get started in trading futures and some of the risks to consider before you jump in. Trading futures isn’t for everyone, so we’ll help you figure out whether it’s a good option for you.
How futures work in 3 steps
Futures are a type of derivative financial contract to buy or sell a specific amount of a commodity or financial instrument at a set future date. Futures products can include everything from gold, oil or wheat to indexes, interest rates or currencies.
Prices of commodities and financial instruments are always changing, and people can use futures contracts to help navigate risk and price uncertainty. With futures contracts, people can lock in a specified price to buy or sell an asset at a future date. This can help limit the negative impact of future price changes.
Market participants who use futures to reduce the risks associated with price uncertainty are known as hedgers.
Let’s look at how this might impact a business, using the cocoa industry as an example.
1. Company A wants to buy a product at a locked-in price, so they seek out a futures contract: A chocolate company decides to buy a cocoa bean futures contract at a specified price because they’re worried cocoa bean prices will go up in the future. They make an offer — or bid — to buy a specific quantity of cocoa beans at a stated price and date.
2. Distributor A sells a futures contract to hedge against declines in prices: A cocoa bean distributor wants to lock in the current price of cocoa beans, for they fear cocoa prices will go down in the future, which would limit profits. So they make an offer to sell a specified quantity of cocoa beans at a given price.
3. The two parties agree on the terms, including the pricing and timing: Once a match occurs, the trade is processed. The cocoa bean futures contract obligates the chocolate company to purchase the stated amount of cocoa beans at the specified price on the set future date and the cocoa bean distributor to make the sale.
Should the price of cocoa beans go up in the future, the chocolate company can rest assured they’re paying a better price. Should they drop, the cocoa bean distributor won’t have to settle for lower profits. A cocoa bean futures contract allows both parties to lock in prices ahead of time.
While futures can help companies dealing with physical products mitigate risk, individual investors who want to bet on future price changes of assets can trade futures purely for profit using a broker that offers futures trading. They simply take up either the buy or sell side of the contract and close out the trade before the delivery date. These types of market participants are known as speculators.
The anatomy of a futures contract
Futures contracts are traded on regulated exchanges. In the US, all futures markets are regulated by the Commodity Futures Trading Commission (CFTC).
And these exchanges are responsible for standardizing the specifications of each contract. These specifications are identical for all participants, which streamlines transferability and the ease of faciltating a trade. For example, one crude oil contract on the Chicago Mercantile Exchange (CME) is always for 1,000 barrels. One contract for gold futures always represents 100 troy ounces.
The specifications of futures contracts are the same for everyone and can be broken down into the following components:
- The unit of measurement: A standardized quantity of the product delivered for a single contract.
- Method of settlement: Futures contracts are either settled financially or physically, where financially-settled futures contracts settle directly into cash at expiration and physically-settled futures contracts settle with physical delivery of the commodity.*
- Quantity of goods to be delivered: The deliverable quantity, or contract size, of the underlying commodity or financial instrument.
- The currency in which the contract is denominated: Specifies what currency is used in the contract, such as whether the asset is priced in US dollars or another denomination.
- The currency in which the contract is quoted: Specifies what currency was used as the contract’s quoted currency.
- Grade or quality of the deliverables, if necessary: For physical products, an exchange will stipulate the acceptable grades of the commodity to ensure quality.
*Brokerages won’t let individual investors actually take physical delivery of products like oil or corn. You’ll either be required to close your position before the delivery date or the brokerage will close it for you.
4 steps to trade futures
Here’s how to trade futures:
- Choose a broker. Compare brokers that support trading futures and choose one that best suits your needs. Established brokers like TD Ameritrade or Charles Schwab include futures trading as part of their brokerage services, while newer investing platforms may not yet have these capabilities.
- Open an account. Expect to provide information about your income, net worth and experience with investing. You will also typically need to apply for, and be approved for, margin privileges in your account.
- Select a futures market to trade in. Choose between financial futures, energy futures, agricultural futures or metals futures. Consider starting with a market you’re familiar with.
- Place your trade. Enter the underlying symbol to find and select the specific futures contract you want to trade. Then, submit an order for execution.
Make sure you understand the risks, margin requirements and expiration date of the contract before you place your trade. With futures, margin is the amount of money you must deposit when you open a futures position. This amount is usually 3% to 12% of the contract’s notional value.
How to choose a broker
Choosing the right platform is an important step in your journey to trading futures, and there are many options out there. While many brokers offer similar services, each broker has its own unique hallmark that could make it more appealing than another. The nice thing is that you aren’t obligated to stay with a specific broker should you decide it isn’t what you want.
As you’re getting started, here are some of the most important things to look for when choosing a broker for trading futures:
- An intuitive, cutting-edge trading platform
- Low per-contract fees
- Low margin rates
- Stability and reliability
- Fast trade execution
- A straightforward pricing and fee structure
- 24/7 trading capabilities
- Excellent customer service
- Access to exchanges around the world
Take some time to shop around and find the broker that best fits your needs. You can also compare brokers below by things like asset types, fees and minimum investment.
Compare trading platforms
Futures contract asset classes
Numerous types of futures products are available for you to trade, but most can be grouped into four primary categories:
- Financial futures: Stock indexes, interest rates and currencies.
- Energy futures: Crude oil, natural gas, heating oil, etc.
- Agricultural futures: Corn, soybeans, wheat, etc.
- Metals futures: Gold, silver, copper, etc.
Stock, bond and cryptocurrency futures
Many globally recognized equity index benchmarks have futures, including the S&P 500, Dow Jones Industrial Average (DJIA) and Nasdaq 100, as well as international indexes such as the Financial Times Stock Exchange (FTSE) 100 and the FTSE China 50.
In December 2017, Bitcoin futures debuted on both the CBOE Futures Exchange (CFE) and the CME, giving traders the ability to bet on future price movements of the popular crypto. Futures have since expanded to include Ethereum too.
Futures vs. forwards
Futures contracts and forward contracts are similar agreements that allow people to buy or sell an asset at a specific price on a future date to mitigate. Both can be used to mitigate risk of future price movements of the underlying asset.
But unlike futures, forwards have highly customizable terms that are privately negotiated between the counterparties. Because of this level of customization, forwards are traded over-the-counter (OTC) and aren’t regulated.
Risks of trading futures contracts
When trading futures, consider your finance experience and financial resources. Futures allow you to leverage a relatively small amount of capital to control a large contract value, which can magnify both your potential returns and losses. This is known as futures margin, and it puts you at risk of losing more than your original investment.
Before you initiate a futures contract, you should know how much you can afford to lose and understand the following risks:
- You can lose more money than you invested.
- You may be required to add more funds on short notice to cover market losses.
- You typically need a high minimum investment.
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