Futures trading isn’t for a beginner, and even more advanced traders require experience. It’s a type of trading that can be found on a variety of markets, and there are applications and platforms that give you a channel into trading in futures. For something that doesn’t sound much like it’s related to stocks and commodities, what exactly is futures, what’s the purpose, and should you get into it? We’ll find out.
What is Futures Trading? – The Breakdown
What is futures trading? You can’t start investing hard-earned money in something you don’t understand, so we’re going to give you a quick breakdown.
Futures are derivative financial contracts. What is the meaning of a derivative? In the case of trading, it’s a contract that “derives” its value from a group of assets, an underlying asset, or a benchmark. Two parties would enter into the contract to agree on either buying or selling the commodity asset or security at a set date in the future (hence the term), for a price that’s also set. Keep in mind that there is a minimum price fluctuation for each contract that is known as a “tick”.
These trades are done on the futures markets or exchanges. In order to take part in futures trading, you would need a brokerage account that is approved to do so.
You may think that it sounds very similar to options trading, and you would be right, but there is one key difference. At the end of the contract, there is no guarantee on the value of options, but in futures trading, the buyer is obligated to purchase the asset and the seller is obligated to provide it.
The Futures Market
We mentioned that futures are traded on futures markets. How are they different from other markets and exchanges? It’s just that it’s dedicated to futures. A typical contract agreement consists of information such as the quantity the buyer commits to buying and the date of delivery for the seller. Examples of futures commodities include oil, metal, coffee, grains, and even currency such as crypto like Bitcoin.
Let’s break down the categories you will most likely find on the futures market or exchange with more examples.
Financial Futures – The E-Mini S&P 500, NASDAQ and Russell 2000, and the Mini Dow Jones.
Currency Futures – Many world currencies such as AUD, CAD, British Pound, Yen, USD
Energy Futures – Natural gas, oil, ethanol
Metal Futures – Gold, platinum, silver, copper, palladium
Livestock Futures – Livestock for consumption such as cattle
Food Futures – Coffee, sugar, cheese
Grain Futures – Corn, soy, wheat, oats
Futures – How Does It Work?
What is trading futures broken down into just a few steps?
Let’s take fuel for example since prices are astronomical at the moment of writing. Let’s say an energy corporation like Chevron and Shell wants to set the price and avoid potential increases in the future. The corporation would become the buyer, looking for contracts from the seller, who would be the fuel distributor, that state the set amount for a set price to be delivered at a set time in the future.
Stock Futures
We talked about the various commodities available in futures trading, but that’s not all you can deal with because there are stock options as well. Individual companies may also have futures stocks as do some ETFs. You may even find futures bonds as well.
Most of us take part in any type of investment because we bet on the value increasing in the future and making us a profit. However, others do short-selling, which is actually making a profit as the stocks fall.
Futures Contracts
We explained what futures contracts are, but let’s go into more detail about what’s stipulated in each one.
- How the trade will go through (physical delivery, cash, etc.)
- The goods quantity
- Currency
- Details regarding the commodity such as grade, quality, etc.
- Unit of measurement
What is the Purpose of Futures?
A big and perhaps the primary reason for trading futures is to hedge against potential risks in price changes. It is one of the best ways for large corporations to do so. So, risk management is a big part of it, but the other half is about speculation.
One thing to understand is before the contract is up, futures trades are highly liquid and can change hands. Why does this matter? It’s a great characteristic for those who do not plan on owning the commodity. What an investor like this does is profit from the direction of the market without being responsible for the follow-through.
Someone who buys and sells before the expiration date will have no obligation to fulfill the terms outlined in the contract. It’s complicated, which is why we do not recommend futures trading for beginners. However, if you want to get into futures and are open to learning and spending time on it, then TopstepTrader is a great option. You can also consider NinjaTrader or Forex.com, but you can try out the free trial for TopStepTrader first and then decide.
Futures Trading – The Pros and Cons
The best way to clearly see if a type of trading or investing is suitable for you is to weigh out the pros and cons.
Pros
- Diversification for your investor profile by spreading assets across various types of investments
- Participate in short selling
- Potential tax benefits
- Speculation due to high liquidity
- Risk management
- The deposit is usually only a fraction of the full amount
Cons
- Requires investing and trading knowledge to be successful
- The margin opens more risks with the chance of more profits
The Benefits
We talked about all the good things that come with futures trading from risk management to short selling. If you meet the criteria to go through with futures trading, then you can reap all the benefits if you understand it.
A brokerage will very likely ask about your investing experience, your total net worth, and even your income to determine the margins and the risk they will allow you to tackle. The commission and fees are set by the brokerage and will vary. It depends on the services they provide as well. There are some firms that offer a ton of support and advice.
The Risks
The futures market is very attractive to those looking to magnify a small amount of investment, especially with short selling. We see people in day trading that borrow money just to play in the futures market. While it is true that you can gain a lot of profit, the reverse is also true and you can lose a lot.
The Commodity Futures Trading Commission (CFTC) warns individual investors about the volatility and recommends against it for those who do not have the capital or experience. Again, there are platforms to use that can give you a taste of futures trading without as much risk as going it alone.
Final Word
The point we are trying to make throughout this article is that futures trading is a very beneficial form of investing to hedge against future price increases and to make a lot of money with a small initial investment when short selling. It’s important to also acknowledge the underlying risk of futures trading, which is high profits can also equal high losses.