Futures trading is a type of financial trading where parties agree to buy or sell a specific asset at a predetermined price on a specific future date. For example, in spot trading, transactions are immediate. But futures contracts lock in the price of an asset for a future settlement. This form of trading is very important in global financial markets because it allows participants to manage risk, speculate on price movements, and ensure price stability for various goods and financial instruments.
Table of contents
- Main Concepts in Futures Trading
- Assets for Futures Trading
- How Futures Trading Works
- The Role of the Exchange
- Advantages of Futures Trading
- Risks of Futures Trading
- Who Should Consider Futures Trading?
- Conclusion
Futures contracts are traded on specialized exchanges. They are used by a wide range of market participants, such as multinational corporations and professional traders. Futures trading is well-structured and standardized, which is why it can be very beneficial. But to use it, you need to understand its mechanics, risks, and benefits. This is what we will check in the article.
Main Concepts in Futures Trading
Here are the main concepts in futures trading, you need to understand them if you want to try this trading type.
A Futures Contract
A futures contract is a legally binding agreement to buy or sell an asset at a specific future date for a fixed price. These contracts are standardized. They are traded on regulated exchanges such as the Chicago Mercantile Exchange (CME) or Intercontinental Exchange (ICE).
Futures contracts can be applied with many assets, such as agricultural commodities (like wheat or coffee), energy products (such as crude oil), metals, stock indices, interest rates, and even cryptocurrencies. Each contract includes the underlying asset, the contract size, the expiration date, and the tick value (the minimum price movement).
Participants in the Futures Market
There are generally three key participants in the futures market.
- Buyers (long position holders). They expect that the price of the underlying asset will rise in the future, and they agree to buy at today’s price.
- Sellers (short position holders). They believe that the price will decline and agree to sell the asset at the current price.
- Exchanges. They are intermediaries and ensure the proper execution of contracts through a clearinghouse. They ensure that both parties complete their obligations.
Assets for Futures Trading
Futures contracts apply not only to physical goods. The underlying asset can be any financial instrument, such as:
- Commodities (oil, gold, corn, etc.)
- Currencies (EUR/USD, GBP/JPY, etc.)
- Stock indices (S&P 500, NASDAQ, etc.)
- Individual stocks and bonds This is why futures trading is suitable for different trading and investment strategies.
How Futures Trading Works
How to Enter a Futures Contract
To enter a futures trade, a trader places an order through a broker. The broker must be connected to a futures exchange. Once the contract is executed, both parties are obligated to either deliver (in the case of physical delivery) or settle the difference in price (in the case of cash settlement) on the contract’s expiration date.
Futures contracts are marked to market daily. It means that the gains and losses are calculated at the end of each trading day. This approach reduces counterparty risk and allows participants to maintain enough margin in their accounts.
Examples
- A hedging example. A wheat farmer expects to harvest in six months and fears a price drop. To secure current prices, the farmer sells a wheat futures contract. If wheat prices fall by the time of harvest, the farmer gets a profit.
- A speculation example: A trader believes oil prices will rise over the next few months. They buy crude oil futures. If the price increases, they can sell the contract at a profit before expiration. If the price drops, they will incur losses.
The Role of the Exchange
Futures exchanges reduce default risk. There are clearinghouses associated with these exchanges. They operate as a counterparty to every trade and guarantee that the buyer and seller meet their financial obligations.
Advantages of Futures Trading
Futures trading can bring significant advantages.
Risk Hedging
Futures trading is very efficient as a risk management tool. Producers, exporters, and investors use futures to hedge against unfavorable price movements. For example, airlines hedge against rising fuel costs, and exporters may hedge against currency fluctuations.
High Liquidity and Accessibility
Major futures markets have very high trading volumes. This is why it is very easy to enter or exit positions quickly. Trading platforms are automated, and this is why futures markets are accessible to retail and institutional traders around the globe.
Leverage Usage
Leverage is often used for futures trading. It means that traders can participate with a small amount of capital. For example, if a futures contract is worth $100,000 and the margin requirement is 10%, a trader needs only $10,000 to open a position. It increases potential returns, but it also boosts risks.
Transparent Pricing and Regulation
Prices of futures contracts are determined by supply and demand. The prices are visible in real-time on public exchanges. These markets are also regulated by financial authorities, which ensures fair trading practices and protection for investors.
Risks of Futures Trading
Futures trading can bring a lot of profit, but it also has some risks.
High Volatility and Potential Losses
The very leverage that enables large profits can also lead to significant losses. Futures markets are often highly volatile, especially in commodities and cryptocurrencies. Rapid price movements can lead to margin calls or even force the liquidation of positions.
Margin Requirements and Margin Calls
Each futures contract requires an initial margin. This is why traders must maintain a certain level of funds, which is known as the maintenance margin. If the account’s equity falls below this level due to losses, it triggers a margin call. The trader must deposit additional funds, or the broker may close positions to prevent further losses.
External Factors that Impact Prices
The prices of underlying assets are often impacted by geopolitical events, macroeconomic news, interest rate changes, weather conditions, and government policies. These factors can cause unexpected price changes.
Who Should Consider Futures Trading?
Futures trading is very complex and risky. This is why it is suitable for those who understand market dynamics and know how to manage risks. Also, such traders shall understand technical and fundamental analysis.
Businesses that work with commodity prices, currency fluctuations, or interest rates often use futures to lock in prices and stabilize costs. For example, an agricultural producer can hedge against falling crop prices. Futures trading can be suitable in the following cases:
- A trader wants to speculate on short-term price movements.
- A company wants to stabilize input costs or revenues.
- An investor wants to diversify a portfolio or gain exposure to specific sectors or commodities.
Conclusion
Futures trading is a powerful financial instrument. It can be used for hedging and speculation. It helps traders and businesses manage risk, take advantage of market opportunities, and potentially enhance returns.
