Many people who enjoy active trading face several hurdles.
First, because the stock market is only open from 9:30am to 4:00pm Eastern, it’s tough to focus on trading while also working a 9-to-5 job. Moreover, the fees associated with active trading can cut into your gains. Plus, you’ll often have to put up a significant amount of money to generate meaningful gains.
Futures help to address all of these problems. The futures market is open much longer and six days per week, contracts come with lower fees, and futures traders can use leverage to create relatively large gains with minimal upfront investments.
But what exactly are futures and how do you go about trading?
What Is Futures Trading?
By their nature, futures are derivative investments that get their value from the underlying commodity or financial asset the contracts are written around.
Futures contracts were invented as a financial instrument to allow commodity producers like farmers and miners to hedge against the possibility of prices dropping at the end of production. If you’re a farmer planning to sell your corn crop, there’s value in locking in your sale price in advance so you know what you’ll net from your efforts.
Hedgers also participate in futures contracts on the buying side. For example, an apple pie company knows that to fulfill orders, it will need thousands of pounds of apples. To avoid the risk of a surge in the price of apples, the company can purchase futures contracts to lock in their pricing in the future.
Similar to the way stocks are traded on stock exchanges, futures are traded on futures exchanges, the most popular of which is the Chicago Mercantile Exchange (CME Group).
As these exchanges and futures contracts became more popular, day traders found ways to make a quick buck by buying and selling the contracts before the expiration date.
A futures trader has no interest in accepting delivery of a large quantity of natural gas, crude oil, wheat, or corn. Instead, traders know futures contracts can be sold over and over again until they expire, and the price changes the agreements experience largely depend on the price movements of the underlying asset.
Therefore, by paying close attention to what’s happening with the underlying asset, a futures trader has the ability to buy and sell futures in a short time frame, setting the stage for fast-paced profits.
Commonly Traded Assets
As mentioned above, when futures first hit the scene, they were primarily designed around commodities, giving miners and farmers, as well as commodity buyers, a way to hedge their bets.
However, with the rise of speculators came new options to consider. Today, when you trade futures, you’ll have access to:
- Currency Futures. Currency is the most in-demand asset in the world, and futures traders often make predictions as to which direction currency pairs are headed.
- Stock Market Futures. Stock market futures, also commonly referred to as index futures, give traders an opportunity to speculate on the direction of major stock market indexes like the S&P 500 or Dow Jones Industrial Average.
- Interest Rate Futures. Finally, interest rate futures give buyers and sellers an opportunity to lock in a contracted rate on the future delivery of an interest-bearing asset or fixed-income security, such as bonds.
Difference Between Futures and Options
If you’ve had any experience with options trading, you’ll notice several similarities between options and futures.
The two are closely related, but there’s one very important difference.
With options contracts, the seller is required to be willing to sell the underlying asset at the contracted rate upon expiration, but the buyer has the option (is not obligated) to buy the asset at that price. If you buy an options contract and hold it to expiration, you can simply let it expire without shares trading hands.
With futures contracts, both parties are bound by the contract, meaning that the buyer must be willing to buy and the seller must be willing to sell the underlying asset upon expiration.
For example, say you purchase a futures contract for the delivery of 1,000 barrels of oil. When the contract expires, the futures buyer will have a contractual obligation to purchase 1,000 physical barrels of oil. Because of this, futures trades who don’t intend to take possession of the underlying commodity must exit their position prior to the contract expiration.
How Are Futures Regulated
Any time you invest in financial markets, it’s important that you make sure you work with regulated brokers. In the United States, the futures market is regulated by the Commodity Futures Trading Commission, or CFTC. It’s the CFTCs job to ensure that the market it oversees is fair and equitable, just like it’s the SEC’s job to ensure that the stock market is fair and equitable.
When trading futures, it’s important to ensure that the brokerage you choose to work with is registered with the CFTC, as this will provide a level of security not experienced with unregulated brokers.
Futures & Margins
Before taking the plunge into futures, it’s important that you understand margins and the dangers of trading on margins. After all, futures accounts are generally margin accounts that have very small initial margin requirements, some as low as 5% or 10%.
The margin requirement is the amount of money you’ll be required to have available for the trade. For example, if you want to trade $10,000 worth of crude oil and your margin requirement is 5%, you’ll only be required to have $500 available to make the trade.
That sounds great, doesn’t it?
Sure, until the trade becomes a big loser.
Whether you’re trading futures, stocks, or any other financial instrument, you’re attempting to predict the future, and those attempts will fail from time to time. When trading without margins, if a prediction fails, the most money you stand to lose is the amount of money you put up in the initial investment. With margin trading, however, the losses can pile up far higher.
For example, let’s say you entered into a futures position on oil worth $10,000 and put the $500 minimum margin requirement up for the trade. Then say oil production skyrocketed and demand tanked. Your oil position is now expected to be worth just $9,000 at the expiration of your contract, for a loss of $1,000.
In this case, your margin wouldn’t cover the losses based on the current market price. As a result, your futures broker will likely issue a margin call, requiring you to deposit more money in your account to cover the losses above and beyond your initial investment.
Why take the risk? Because if the value of your oil position climbs to $11,000, you’ll be able to sell your position for a large profit relative to your upfront investment. This is why margins represent a high-risk/high-reward investment opportunity.
Different Types of Futures Contracts
There are several different types of futures contracts. It’s important to know what these different contracts represent before diving in. The three most common types of contracts include:
Standard or full-size futures contracts represent a large amount of the underlying commodities or financial assets. These are the types of contracts that were designed to give farmers and large-scale buyers a way to solidify pricing in the future.
For example, if you purchase a standard futures contract surrounding corn, the contract will represent 5,000 bushels of corn — about 140 tons — for physical delivery upon the expiration of the contract. Oil futures are generally sold in 1,000-barrel increments, while Treasury Bond futures usually have a face value of $100,000.
E-mini futures contracts were designed to make it possible to trade smaller amounts. These contracts cater to investors interested in trading futures but not in trading $25,000 worth of corn at a time.
Cash Settlement Futures
Finally, cash settlement futures are the only futures contracts that don’t end in the physical delivery of the underlying asset. Instead, when these futures expire, the cash value of the physical asset is transferred to the buyer, rather than the asset itself.
Pros & Cons of Futures Trading
As with any other trading style, futures trading comes with its own set of pros and cons. Before getting started trading futures contracts, it’s important to understand the most significant risks and rewards.
Futures contracts have become a popular asset to trade because of their perks. Some of the most exciting aspects associated with trading futures include:
1. High Liquidity
Futures contracts tend to come with high levels of liquidity. This is a result of those who actually need the assets bidding in conjunction with those who speculate on price movement. High liquidity ultimately means you’ll be able to exit your position quickly should you decide the time has come.
2. More Time to Trade
The stock market is open from 9:30am to 4:00pm Eastern, when the average American is at work. However, the futures market is open nearly 24 hours per day, Sunday through Friday. There is a halt every trading day from 4:15pm to 4:30pm Eastern, but otherwise trades can be made at any time.
Because futures are traded on margins, the potential returns on these contracts are generally far higher than potential returns on trades that occur without margins.
Sure, there are plenty of reasons to be excited about trading futures, but as with any other financial instrument, there are a few drawbacks to consider before you get started. Some of the most significant include:
1. Increased Loss Potential
Any time margins are involved, it’s possible to lose more than your initial investment on a trade. Sure, the potential for increased returns is exciting. However, it’s important to keep the risks in mind and be prepared to act if things turn in the wrong direction.
2. No SIPC Insurance
When trading and investing in stocks, your investments are usually covered by Securities Investor Protection Corporation (SIPC) insurance. If your broker goes belly up, your money won’t be sleeping with the fishes.
However, commodity futures generally aren’t covered by SIPC insurance, leaving your investments unprotected. That makes it extra important to trade only with a stable futures broker.
3. High Minimum Investments
When trading stocks, there are several apps that allow you to open an account with no minimum deposit. This makes it easy to dabble with small amounts of money and decide whether trading is right for you.
However, most futures brokers require new members to make a minimum deposit of at least $1,000. For newcomers to the futures trading world, a $1,000 minimum investment in something they’re not 100% sure they’ll want to stick with can be a big leap of faith.
All told, the futures trading industry is an exciting, highly liquid, fast-paced playing field on which the top players make serious money. At the same time, it has become a necessity that helps to support the thriving United States economy and the commodity producers that operate within it.
However, if you’re going to trade futures, it’s important to keep the risks in mind, specifically the risk of a single bad trade wiping out far more than your initial investment.
As with just about any trading strategy, research is the key to your success. By ensuring that your trades are well researched and thoughtfully placed, you’ll be able to alleviate yourself of much of the risk associated with trading in the space.