A Guide to Futures Trading
Futures are a widely used leveraged instrument, particularly popular among commodity traders. This guide explains the essentials of futures contracts, how they function, and how you can start trading them.
What is a Futures Contract?
A futures contract is a legally binding agreement to buy or sell an asset typically a commodity at a predetermined price on a specific date in the future.
Delivery Obligation: Futures contracts come with an expiry date, meaning the contract holder must take delivery of the asset like a barrel of oil on that date, unless they settle the contract in cash.
Speculation: Futures aren’t just for delivery; they can be used to speculate on price changes. If you expect an asset’s price to rise, you can lock in a lower price. Conversely, if you think prices will drop, you can set a higher selling price.
Originally designed to stabilize prices and manage risk especially in agriculture where farmers needed to secure prices for crop futures now serve a significant role in speculation. Traders can settle contracts in cash, avoiding the actual delivery of the physical asset. Like other derivatives, futures are leveraged, offering the potential for substantial gains or losses.
How Does Futures Trading Work?
The mechanics of futures trading can vary depending on whether you’re trading on an exchange or through an over-the-counter (OTC) arrangement.
Exchange-Traded Futures: When trading on an exchange, you deal in standardized contracts with fixed quantities, qualities, and expiry dates. For instance, a WTI oil futures contract on the New York Mercantile Exchange (NYMEX) involves 1,000 barrels of oil.
If WTI futures are priced at $70 per barrel, the total contract value is $70,000 (70 x 1000). However, due to leverage, you only need to deposit a fraction of this amount to open a trade.
Over-the-Counter Futures: OTC futures, or forward contracts, are negotiated directly between two parties without a central exchange. These contracts lack the standardization and regulatory oversight of exchange-traded futures, and come with the risk of counterparty default where one party fails to meet their obligations.
Futures Trading Example
Imagine you’re a food producer needing to lock in a wheat price of $200 per tonne for delivery in three months. By buying wheat futures at this price, you ensure that, regardless of whether the spot price rises to $250 per tonne, you can still purchase wheat at $200.
Conversely, if the spot price drops below $200, you’ll still need to buy at the agreed higher price, which might not be ideal, but this is a trade-off for price certainty.
What Futures Markets Can You Trade?
Commodities: Futures are often associated with commodities like crude oil, corn, natural gas, soybeans, and wheat. These markets were originally created to help manage price risks for farmers and producers. Today, commodity prices are frequently derived from futures contracts, and even spot prices are calculated based on nearby futures contracts.
Stock Index Futures: Futures can also be used to speculate on stock market indices. Index futures represent a collection of stocks and are the basis for other derivatives like spread bets and CFDs. You can trade index futures outside regular market hours, such as the Dow Jones Industrials futures, which are available before the New York market opens. Traders often use these futures prices as indicators of market trends.
How to Trade Futures
You can engage in futures trading through spread bets or CFDs, where you speculate on whether the futures contract price will rise or fall before the contract expires.
Speculating: With spread bets and CFDs, you don’t need to take delivery of the asset. Instead, you settle the contract in cash or roll it over into a new expiry period. This approach allows you to manage your positions flexibly without the need for physical asset delivery.
By understanding these fundamentals, you’ll be better prepared to navigate the futures markets and leverage their potential for strategic trading.