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What are futures?
Futures are derivative contracts to buy or sell an asset at a future date at an agreed-upon price.
That asset might be soybeans, coffee, oil, individual stocks, exchange-traded funds, cryptocurrencies or a range of others. Futures contracts can be used by many kinds of financial players, including investors and speculators, as well as companies that actually want to take physical delivery of the commodity or supply it.
Oil, for example, is a commodity that can be traded in futures contracts. Investors can also trade S&P 500 futures contracts — an example of stock futures investing.
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What is a futures market?
A futures market is an exchange where investors can buy and sell futures contracts. In typical futures contracts, one party agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party agrees to provide it.
» Learn more: What are the best commodity ETFs?
Most participants in the futures markets are consumers, or commercial or institutional commodities producers, according to the Commodity Futures Trading Commission. Commodity futures and options must be traded through an exchange by people and firms registered with the CFTC.
To decide whether futures deserve a spot in your investment portfolio, consider the following.
Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel:
An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.
A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices.
Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.
In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it's the basis of their business. They use the futures market to manage their exposure to the risk of price changes.
But not everyone in the futures market wants to exchange a product in the future. These people are futures investors or speculators, who seek to make money off of price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they're just in the market to wager on price movements.
With speculators, investors, hedgers and others buying and selling daily, there is a lively and relatively liquid market for these contracts.
Stock futures investing
Commodities represent a big part of the futures-trading world, but it's not all about hogs, corn and soybeans. Stock futures investing lets you trade futures of individual companies and shares of ETFs.
Futures contracts also exist for bonds and even bitcoin. Some traders like trading futures because they can take a substantial position (the amount invested) while putting up a relatively small amount of cash. That gives them greater potential for leverage than just owning the securities directly.
Most investors think about buying an asset anticipating that its price will go up in the future. But short-selling lets investors do the opposite — borrow money to bet an asset's price will fall so they can buy later at a lower price.
One common application for futures relates to the U.S. stock market. Someone wanting to hedge exposure to stocks may short-sell a futures contract on the Standard & Poor’s 500. If stocks fall, they make money on the short, balancing out their exposure to the index. Conversely, the same investor may feel confident in the future and buy a long contract – gaining a lot of upside if stocks move higher.
» Is day trading a better fit? Learn how to day trade
What are futures contracts?
Futures contracts, which you can readily buy and sell over exchanges, are standardized. Each futures contract will typically specify all the different contract parameters:
The unit of measurement.
How the trade will be settled – either with physical delivery of a given quantity of goods, or with a cash settlement.
The quantity of goods to be delivered or covered under the contract.
The currency unit in which the contract is denominated
The currency in which the futures contract is quoted.
Grade or quality considerations, when appropriate. For example, this could be a certain octane of gasoline or a certain purity of metal.
If you plan to begin trading futures, be careful because you don't want to have to take physical delivery. Most casual traders don't want to be obligated to sign for receipt of a trainload of swine when the contract expires and then figure out what to do with it.
» Explore other alternative investments: Learn how to invest in real estate
The risks of futures trading: margin and leverage
Many speculators borrow a substantial amount of money to play the futures market because it’s the main way to magnify relatively small price movements to potentially create profits that justify the time and effort.
But borrowing money also increases risk: If markets move against you, and do so more dramatically than you expect, you could lose more money than you invested. The CFTC warns that futures are complex, volatile, and not recommended for individual investors.
Leverage and margin rules are a lot more liberal in the futures and commodities world than they are for the securities trading world. A commodities broker may allow you to leverage 10:1 or even 20:1, depending on the contract, much higher than you could obtain in the stock world. The exchange sets the rules.
The greater the leverage, the greater the gains, but the greater the potential loss, as well: A 5% change in prices can cause an investor leveraged 10:1 to gain or lose 50 percent of her investment. This volatility means that speculators need the discipline to avoid overexposing themselves to any undue risk when investing in futures.
If such risk seems too much and you're looking for a way to shake up your investment strategy, consider trading options instead.
» Learn more: Read up on how to trade options.
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How to start trading futures
It's relatively easy to get started trading futures. Open an account with a broker that supports the markets you want to trade. A futures broker will likely ask about your experience with investing, income and net worth. These questions are designed to determine the amount of risk the broker will allow you to take on, in terms of margin and positions.
There's no industry standard for commission and fee structures in futures trading. Every broker provides varying services. Some provide a good deal of research and advice, while others simply give you a quote and a chart.
Some sites will allow you to open up a paper trading account. You can practice trading with “paper money” before you commit real dollars to your first trade. This is an invaluable way to check your understanding of the futures markets and how the markets, leverage and commissions interact with your portfolio.
If you’re just getting started, we highly recommend spending some time trading in a virtual account until you’re sure you have the hang of it.
Even experienced investors will often use a paper trading account to test a new strategy. Some brokers may allow you access to their full range of analytic services in the paper trading account.
» Ready to get started? See our picks for the best brokers for futures trading
As a seasoned expert in financial markets and trading, I've navigated the intricate landscape of various investment instruments, including futures contracts. With years of hands-on experience and a deep understanding of the concepts involved, I'm well-equipped to shed light on the nuances of futures trading and its implications for investors.
Now, let's delve into the key concepts highlighted in the provided article:
1. Futures Contracts:
- Futures contracts are derivative financial instruments that obligate the buyer to purchase, or the seller to sell, a specific quantity of an asset (commodity, security, etc.) at a predetermined future date and price.
- The article mentions various assets traded through futures contracts, such as soybeans, coffee, oil, individual stocks, exchange-traded funds (ETFs), and cryptocurrencies.
2. Futures Market:
- The futures market is the platform or exchange where investors engage in buying and selling futures contracts.
- Participants in the futures market include consumers, commercial or institutional commodities producers, investors, and speculators.
- The Commodity Futures Trading Commission (CFTC) oversees and regulates commodity futures and options trading, requiring participants to be registered.
3. Using Futures:
- Investors and companies can use futures contracts to secure specific prices and hedge against potential price volatility.
- The article illustrates the use of futures in the example of an airline company locking in jet fuel prices and a fuel distributor ensuring a steady market for fuel.
- Participants in the futures market can be hedgers (companies needing the underlying commodity) or speculators seeking to profit from price movements.
4. Stock Futures Investing:
- Stock futures investing allows traders to engage in futures contracts tied to individual companies, shares of ETFs, bonds, and even cryptocurrencies like bitcoin.
- Traders in stock futures can take substantial positions with a relatively small amount of cash, offering greater potential for leverage compared to owning the securities directly.
5. Characteristics of Futures Contracts:
- Futures contracts are standardized and specify various parameters:
- Unit of measurement.
- Settlement method (physical delivery or cash settlement).
- Quantity of goods to be delivered.
- Denomination currency.
- Quoted currency.
- Grade or quality considerations for specific commodities.
6. Risks of Futures Trading:
- Futures trading involves the use of margin and leverage, allowing traders to magnify potential profits but also increasing the risk of substantial losses.
- The CFTC warns that futures are complex, volatile, and not recommended for individual investors.
7. Leverage and Margin Rules:
- Leverage and margin rules in the futures and commodities market are more liberal than in the securities trading world.
- Commodities brokers may offer leverage ratios such as 10:1 or 20:1, allowing for significant gains but also amplifying potential losses.
8. How to Start Trading Futures:
- Getting started in futures trading involves opening an account with a broker supporting the desired markets.
- Brokers assess a trader's experience, income, and net worth to determine permissible risk levels.
- The article recommends practicing in a paper trading account to gain familiarity with futures markets before committing real funds.
By providing insights into these concepts, I aim to equip individuals with a foundational understanding of futures trading and its various aspects.