Futures trading is a phrase many laypeople have heard kicking about. But unless you’re in the industry, you may not fully understand what it means and how it works. For anyone considering entering the world of futures trading, it’s always useful to have a basic breakdown.
What is a futures trading contract?
Think of a futures contract as an agreement between two parties to buy (or sell) an asset for an agreed price at a later set date. Futures trading contracts are standardised agreements. These agreements will usually trade on an exchange. For example, the buyer will agree to buy a commodity or a specific quantity of securities on an agreed date, and the seller formally contracts to providing it.
All kinds of financial traders play the futures market, including speculators, individual investors and companies that supply or receive the commodity itself. If you’re considering including futures in your investment portfolio, the information in this blog will help you decide.
This is how futures work for market traders
By allowing traders to secure a definite specific price for a future date, future trading contracts protect against wild swings in value – either up or down.
Let’s take crude oil as an example commodity.
- A company that wants to ensure crude oil prices are locked in so that they don’t have to face an unexpected leap might buy a futures contract.
- The contract will agree to buy a certain amount of crude oil for delivery on a future date at a specific price.
- A crude oil distribution company might sell a futures contract so that it knows there is a steady market for its product and to ensure prices don’t decline.
- Both bodies agree on specific terms for the futures contract – this could be to sell or buy 500,000 barrels of oil for delivery in 60 days at a cost of $69/barrel.
This example covers how companies use the futures market. Both the buyer and seller here are hedgers that trade in this commodity because it’s the basis of their business. In this case, these companies are using the futures trading market to control the risk of price fluctuations.
However, the futures market is not only used by companies trying to control future prices. As well as the companies that exchange the physical product as their core business action, investors and speculators also use the market. They are using it different – to try and make money from the price changes in the contract.
Continuing the crude oil example, if the price increases then the futures contract becomes more valuable. Therefore, the body that owns the futures contract could choose to sell it for more money within the futures market. These kinds of traders have no intention of every taking delivery of the commodity – in this case crude oil. Instead, they speculate on price movements within the market.
Commodities aren’t the only options within futures trading
While commodities are responsible for much of the trade within the futures market, you can also trade futures of other assets. These include bonds, individual stocks, cryptocurrency and shares of exchange traded funds (ETFs).
Traders choose to trade in this way because they can trade with relatively small amounts of cash. This gives traders much more leverage and potential for making money than outright owning the securities. The majority of investors consider buying an asset on the basis that it will be worth more in the future. Short-sellers do the opposite – they borrow money to speculate that the price will fall so they can buy in the future for a lower price.
Futures contracts can be easily bought and sold over exchanges. They are standardised contracts, which specify everything necessary, including:
- The way in which the trade will be settled. This will either be by a delivery of a specified quantity of physical goods or with cash.
- The unit of measurement.
- The quantity of commodities to be covered or delivered.
- The currency unit used in the contract.
- Any quality considerations, such as purity of metals or grade of fuel.
If you’re just starting out in trading futures, you must ensure you don’t agree to take a physical delivery of the commodity. Casual traders generally don’t want to deal in the physical goods when the contract ends.
Trading education course is a good plan for newcomers to futures trading
There are, of course, risks involved with futures trading. Many traders and speculators choose to borrow large amounts of money to strategise within the futures market. This is because the market offers the chance to multiply relatively small movements in price to make profit.
Borrowing money increases the risk of losing more than you initially invested, should the market move in the wrong way. Because leverage is more flexible in the commodities and futures sphere than in securities trading, there is the chance of making big gains. However, this means that the potential loss is also greater.
Speculators need to be aware of the market volatility and carefully manage their strategy to ensure they don’t become overexposed to too much risk. If this amount of risk is too much for your investment strategy, then you could look into trading options instead.
It’s easy to start trading in the futures market. Beginners can either choose to open an account with a futures broker or open an online trading account and go it alone. A virtual trading account usually allows you to practice trading first before committing real money to a trade.
This is a great way to understand the futures market, and I definitely recommend trading with a virtual account. Even experienced investors and speculators often use virtual trading accounts when developing new investment strategies. Along with a professional trading education course, experimenting with these dummy platforms will help you understand how to make a solid income.