Futures trading is a fast-paced, risky and sometimes lucrative strategy that is most often used for hedging and speculation. Futures contracts are the trading vehicle. They call for the purchase or sale of an asset at some future date but at a price that is fixed today. The world’s largest marketplace for futures trading, CME Group, is composed of exchanges. Two of the most well-known exchanges are the Chicago Board of Trade and the Chicago Mercantile Exchange. There is also the New York Mercantile Exchange. Here’s what you need to know about futures.
If you’re new to futures or just considering them, work with a financial advisor to make sure you avoid pitfalls and get a clear understanding of what’s involved.
Until the 1970s, there were only commodity futures. Current examples of popular commodity futures contracts are wheat, corn and sugar in the food category. Energy futures include oil and gas. Popular metal futures are gold, silver and copper. In 1975 financial futures such as foreign currencies, Treasury securities and stock indexes were introduced. You can even buy futures on Bitcoin.
Futures are derivative securities because they derive their value from an underlying asset. They’re similar to options, but whereas options are, as the name suggests, optional, a futures contract is obligatory. When an options contract expires you can decide whether to follow through with it or just walk away. If you walk, you’re only out the money you spent to arrange the contract. A futures contract obliges both parties in the contract to fulfill their end of the bargain.
Understanding Futures: Margin Requirements
There are margin requirements with futures trading because of the risk involved and the fraud that exists in the futures market. If you want to trade in futures, you must set up a margin account with your broker. The margin on futures is normally 3% to 12% of the total value of the futures contract. The margin on futures works differently than the margin on stocks. It is not an upfront payment on the contract. Instead, it is the amount you have to keep in your account to fund your futures position. This is called the initial margin.
If you have losses in your futures position, you have to deposit more money into your margin account to bring the margin percentage back to the initial margin. This is the maintenance margin. When you are asked to deposit more money for the maintenance margin, that is a margin call.
Trading on the margin also means that you don’t have to deposit the full amount of the futures contract if you want to buy. As an example, let’s say you buy futures contracts on a financial asset for $100,000. Your broker’s margin requirement is 7%. Instead of paying the full $100,000, you pay $7,000. If the current price for your futures contract starts to fall, your margin account will have to make up for those losses. If it continues to fall, you will run out of money in your margin account and get a margin call from your broker. You will be required to deposit more money to make up for the loss.
The margin requirements increase the risks of futures trading since you can also lose that money in addition to your position on your futures contracts. Trading on the margin means that you are using leverage which can magnify any gains you get, but it also increases your losses.
Understanding Futures: An Example
Consider a futures contract on corn. If the buyer agrees to buy a futures contract on 10,000 bushels of corn for $2 per bushel with a 90-day expiration date, he would have to pay $20,000 for the corn no matter how far the price drops. The seller first has to buy the corn at the market rate and then sell it back at $2 per bushel. If the price of corn goes up due to severe weather conditions or insect damage to the crops, the seller will only receive a payment of $20,000 for the corn regardless of how high the price climbs in 90 days. This is what makes commodity futures particularly risky.
Speculators are only interested in the price movements of the underlying asset. One other factor that increases the risk inherent in futures trading is that commodities are marked to market daily. This means that the price changes constantly. Consider investing in commodity index funds instead of directly in commodities futures.
Trading in Currency Futures
Trading in foreign currency futures is popular among speculators and seasoned investors. Currency futures, also called foreign exchange futures, are traded with a clause stating that settlement will be in cash and the buyer will not take delivery. The investors are trying to make a profit, so the futures contract is written so that physical delivery does not occur.
There are around 50 foreign currencies on the currency market. Currencies are exchange-traded so this type of futures trading is subject to rules and regulations such as centralized pricing. The risk is still there. Currency traders often hold their futures contracts for very short periods of time. The liquidity of the currency market varies from currency to currency. The market for Euros/U.S. dollar is highly liquid with a lot of trading going on. The market for New Zealand/U.S. dollar is not nearly as liquid with only a few contracts traded each day.
To manage the risk in the currency market, one strategy is to trade only in currencies for countries with a strong, stable currency.
Trading in Index Futures
Another popular asset traded on the futures market is market index futures. You can have futures contracts on the S&P 500, the Dow Jones Industrial Average, the NASDAQ 100 and others. There are also futures contracts on indexes traded on foreign exchanges such as the DAX in Germany. Index futures allow speculators to try to profit from movements in the market index. Portfolio managers use them to hedge against losses in stocks. Investors use them to try to magnify their returns. These futures contracts are based on the underlying asset which is the market index. Participants are, in effect, betting on the direction the market will move.
Due to the riskiness of trading index futures, the Financial Industry Regulatory Authority (FINRA) requires a margin of 25%, deposited with your broker, to trade in index futures.
The Bottom Line
Investors in the futures markets must understand the complexities of the market and the high degree of financial risk they are assuming. Unlike options contracts, futures contracts are legally binding. Many brokers will require that participants in the market use a market simulator or something similar to practice trading techniques before they ever start trading in the open market. The “Best Trading Platforms for Futures in 2021” article can point you in the right direction.
Tips for Investing
- Since the futures market is only for experienced traders and not for the faint of heart, consult a financial analyst to assist you. You can use the SmartAsset matching tool to quickly find financial analysts you might want to work with. If you are ready to be matched with a local advisor who will help you achieve your financial goals, get started now.
- Depending on your investment time horizon and risk preferences, investing in futures may or may not be a good idea for you. Check out our asset allocation calculator, which will help you determine the types of investments best for you to achieve diversification.
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