Futures are a derivative and comprise an agreement between a buyer and seller to trade a commodity, security, or asset at a specific future date at an agreed price.
Whatever the market price, the buyer must buy, and the seller must sell on the expiry date.
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Investors use futures for two reasons – a hedge against the potential of price risk on an asset within their portfolio or to speculate how a commodity or stock will change in value.
Traders can generally buy or sell futures at any point before the contract expires, accessing different markets, hedging currency risks, or taking a position in a specific industry, such as energy or cryptocurrency.
Futures Trading Explained
The basis of futures is relatively simple. First, the buyer purchases the contract, which acts as a financial instrument and locks in an asset or commodity sale or purchase at a fixed price, and on a specified date.
Futures are commonly used in forex, for example, where a business needs assurance that it can access the currency required to settle international contracts in the future without the settlement costing more than they have budgeted if the exchange rate rises.
However, many futures contracts are speculative or used to mitigate risk and end up cash settled rather than a physical commodity changing hands.
Investors use futures to speculate on almost any commodity or security, including:
- Stock indices
- Energy markets
- Interest rates
Some online trading brokers offer futures contracts, or investors can trade through a centralised exchange.
Benefits Of Trading Futures
Investors can trade futures on a margin basis, allowing them to borrow leverage from their broker to increase their position size. The outcome is that the possible gains are multiplied, but there is an equal increase in the size of the associated risk.
The advantage is that a trader can control a powerful position with a relatively small margin. However, this can be disastrous if the value of the underlying stock or asset moves in the wrong direction and exacerbates their loss.
Traders often use futures to diversify their portfolios or to offset a risk linked with another asset. They can trade futures on almost anything to spread their fund across asset classes, sectors, markets, and countries.
The other typical use of futures is to protect investment assets from losses or safeguard anticipated returns.
For example, if a producer needs to purchase wheat in a specific month of the year, they might buy a futures contract expiring around the same time to protect them from the risk of price rises on the spot markets.
Commodity producers also use futures, taking a short position and selling a product through a contract for a pre-scheduled delivery date. Then, they are guaranteed to sell at that price when the contract matures.
Downsides To Trading Futures
Leverage can be good or bad – it can enhance returns and allow traders to take more prominent positions without a large capital injection. Still, it can also mean exposure to substantial losses and potential margin calls.
Futures contracts have established expiry dates, which can affect the value of the financial instrument if a trader expects to sell – nearly mature futures are usually worth less. One option is to roll forward futures to an extended expiry date to avoid losing value.
If a futures contract expires without a closing agreement or sale, the investor must take delivery of the underlying asset.
Understanding Futures Contracts
Any investor needs to analyse the stock or asset in question and evaluate the content of a potential futures contract to determine what position to take and identify the risk levels.
- Contract size indicates the volume or value of the underlying asset linked to the futures contract. For example, that might be a count of a commodity, a cargo of raw material, a number of shares, or a specific number of currency units.
- Contract value shows what the futures contract is worth based on the size and price. For example, a futures contract worth 500 shares traded at £500 each has a contract value of £250,000.
- Tick size is the minimum price change associated with a futures contract or the smallest amount the contract price can change by.
Regulated trading platforms will provide all the data and metrics behind the asset to help traders calculate the potential losses and returns and make informed decisions.
However, it is important to remember that leveraged futures can be worth much more or less, so total loss exposure could be significantly greater.
Types Of Futures
Futures allow traders to invest in various commodity-based and financial contracts, including debt, energies, agriculture, indexes, and currencies.
The below list shows some of the many potential examples. However, it is not exhaustive:
- Financial futures: index contracts and futures on interest rates are common, with exposure to specific market indices or the interest rate charged on a debt instrument.
- Currency futures: speculating on currency pair valuations or hedging the risk of a currency exchange rate. Traders can also buy futures contracts on cryptocurrencies.
- Energy futures: allow investors to trade against energy products businesses, individual consumers, and governments use.
- Metal futures: futures contracts linked to metals include steel and gold futures, often used by institutional investors to hedge potential future costs of raw materials.
- Grain futures: futures traded against market prices of raw grains used for food processing, agricultural and commercial purposes.
Investors can trade futures options, sometimes using comparable trading strategies for equity trades, whether as a market-neutral hedge, to reduce portfolio risk, or to trade in more volatile markets at a reduced exposure and cost.
Options work similarly to futures, although they are not obligatory – the buyer can choose whether to exercise their option when the contract expires.
Taking options on futures is a more complex trade but allows investors to make considered judgements about the potential profits or losses on a futures contract.
Creating A Futures Trading Strategy
It is important to have a trading plan that outlines when you will enter or exit a futures trade, ensuring that each position is consistent with your approach to risk management.
Futures trades can comprise:
- Long trades – buying futures and expecting to profit when the asset price increases.
- Short trades – selling futures to make a profit when prices drop.
- Spreads – profiting from the relative price difference between futures contracts, often used for two related futures, such as oil and gas.
Traders can use technical analysis to predict how markets will move and decide to take long futures trades based on indicators such as moving averages. Stop losses can also be a useful element of a trading plan and dictate when you choose to mitigate downside risk or prevent a loss from becoming greater.
Other strategies are based on fundamental analysis, interpreting wider economic signals to make decisions about future asset and currency values based on economic and political factors.
Most investors use both technical and fundamental analysis to estimate how profitable a futures contract might be.
Trading Futures FAQ
Almost any – traders can use futures to buy or sell any asset, such as a stock, currency, or commodity, at a future date and a confirmed price. Investors might buy or sell futures in ETFs, cryptocurrencies, or commodities such as coffee, oil, or gas.
Futures are a trading contract where investors use derivatives to speculate on asset prices or commodity values or hedge a position within their portfolio to mitigate risk.
Trading platforms provide leverage for futures, which can increase profitability or exacerbate the loss. Both parties must settle their end of the contract at the expiry date, regardless of how markets or values have moved in the interim.
Many futures are cash-settled rather than a physical commodity changing hands, which is more common in investment speculation.
Most futures contracts have an expiry date, although some open-ended futures do not. Traders need to either roll over the agreement before the contract ends or close out their position if their futures contract is approaching expiry and they do not want to receive the commodity.
Although futures are primarily considered investment products, they are also useful for companies that purchase specific assets or rely on raw materials. For example, an airline might buy futures to lock in the price of jet fuel.
To access the futures market, you will need an online trading account with a broker offering futures contracts and in the types of assets or markets. It is advisable to start with a dummy account, also known as paper trading, to practise trades and strategies before putting capital at risk.
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