How to trade futures contracts
Futures contracts, or so-called forward contracts, are a type of derivative contract agreement to buy or sell a specific commodity asset or security at a specified future date for a specific price. Futures contracts, or simply “futures contracts”, are traded on futures exchanges such as CME Group and it is required to have an accredited brokerage account to trade futures contracts.
A futures contract involves both a seller and a buyer, similar to an options contract. Unlike options, which can become worthless at expiration, when the futures contract expires, the buyer is obligated to purchase and take delivery of the underlying asset and the seller of the futures contract is obligated to provide and deliver the underlying asset.
Explanation of futures trading
Uses of futures contracts
Futures contracts are generally used for two uses in investing: hedging (risk management) and speculation.
Hedging with Futures Trading: Futures contracts that are bought or sold with the intent of receiving or taking delivery of the underlying commodity are typically used for hedging purposes by institutional or corporate investors, often as a way to help manage the future price risk of that commodity on their operations or investments.
Futures Contract Speculation: Futures contracts are generally liquid and can be bought and sold up to the time of expiry. This is an important feature for speculative investors and traders who do not and do not want to own the underlying commodity. They can buy or sell futures contracts to express an opinion about – and potentially profit from – the market direction of a commodity. Then, before expiration, they will buy or sell a futures position as an equivalent to get rid of any obligation to the physical commodity.
Why trade futures contracts?
Futures contracts are often used by individual investors and traders as a way to speculate on the future price movement of an underlying asset. They seek to make a profit by giving their opinion on where the market might go for a particular commodity, index or financial product. Some investors also use futures contracts as a hedge, usually to help offset future market movements in a particular commodity that might otherwise affect their portfolio or business.
Of course, stocks or ETFs can similarly be used to speculate or hedge against future market movements. They all have their own risks that you need to be aware of, but there are some distinct benefits that the futures market can offer that the stock market does not.
Establishing an equity position in a margin account requires that you pay 50% or more of its full value. In futures contracts, the amount of initial margin required is usually set between 3-10% of the value of the underlying contract. This leverage gives you the ability to make greater returns compared to the amount of money invested, but it also puts you at risk of losing more than your original investment.
Futures provide some ways to diversify your investments in ways that you cannot diversify your investments with stocks and ETFs. Futures contracts can give you direct market exposure to a commodity asset versus ancillary market products such as stocks. In addition, they allow you to access specific assets that are not usually found in other markets. Futures contracts can also be used if you are looking for strategies designed to help manage some of the risks surrounding upcoming events that could move the markets.
In futures contracts, margin requirements are the same for long and short positions. This allows for a bearish position or a reversal of the position without additional margin requirements.
Futures contracts can provide a potential tax advantage over other short-term trading markets. This is because profitable futures trades are taxed on a 60/40 basis. 60% of the profits are taxed as long-term capital gains and 40% as ordinary income. Compare this to stock trading, where dividends held for less than a year are taxed 100%.
Customers should consult a professional tax advisor for their specific tax advice needs.
Types of future contracts
The types of forward futures contracts available for trading include a wide range of financial and commodity-based contracts, from indices, currencies, and debt to energies and metals, to agricultural products.
financial futures contracts
Index contracts and interest rate (debt) contracts are two types of financial futures contracts. Index contracts provide exposure to specific market index values, while interest rate contracts are used for exposure to the interest rate of a particular debt instrument. Examples:
E-Mini S&P 500
E-Mini Russell 2000
Mini Dow Jones
E-mini Mid-Cap 400
Micro E-minis (multiple indices)
Bloomberg Commodity Index
Nikkei 225 (CME)
U.S. Treasury Bonds
U.S. 10-Year Notes
U.S. 5-Year Notes
U.S. 2-Year Notes
Currency contracts provide exposure to the exchange rate of a real currency or cryptocurrency. Examples:
U.S. Dollar Index
New Zealand Dollar
South African Rand
Energy contracts provide broader exposure to the prices of common energy products that are used by companies (for manufacturing, production or transportation), governments and individuals for consumption purposes. Examples:
Brent Crude Oil
Metals futures provide exposure to the prices of certain metals that many companies rely on as materials for manufacturing and construction (for example, gold for computers or steel for housing). Examples:
HRC Steel Index
Grain contracts provide exposure to the price of raw grain materials used in animal feed and commercial processing into other products (such as ethanol and corn syrup), as well as processed soybeans. Examples:
Livestock contracts provide exposure to the prices of live animals used in the supply, processing and distribution of meat products. Examples:
Food and fiber futures
These contracts provide exposure to the prices of agricultural products grown versus extracted products and the prices of dairy products. Examples:
Futures options trading
A futures option works similarly to a stock option. You can even use some of the same options strategies. Trades in options on futures contracts can include market neutral, multilateral and directional trades, depending on which way you think the market will move and your risk/reward objectives.
The advantage that these options have over futures contracts is the ability to reduce the risk in your portfolio in various ways. Whether you are looking to trade in an uncorrelated market to diversify risk, hedge existing positions to reduce risk, or outright trade in more volatile markets at a reduced cost versus futures contracts alone, options on futures contracts can be a way to do it.
The pros and cons of futures trading
Ease of betting on the underlying asset: Selling futures contracts can be easier than shorting stocks. In addition, you get access to a variety of assets.
Simple Pricing: Futures prices are based on the current spot price and adjusted for the risk-free rate of return to expiration and the cost of physical storage of the commodity to be physically delivered to the buyer.
Liquidity: The futures markets are characterized by high liquidity, which makes it easy for investors to enter and exit positions without high transaction costs.
The positive effect: Futures trading can provide greater leverage than a standard brokerage account. You may only get 2:1 leverage from a stock broker, but with futures contracts you can get 20:1 leverage. Of course, the higher the leverage, the higher the risk.
An easy way to hedge positions: A strategic futures position can protect your business or investment portfolio from downside risks.
Sensitivity to price fluctuations: If your position moves against you, you may have to provide more cash to cover the maintenance margin and prevent your broker from closing your position. And when you use a lot of leverage, the underlying asset doesn’t have to move as much to force you to put up more money. That can turn a potential big winner into mediocre trades at best.
* Lack of control over the future: Futures traders also carry the risk that the future is unpredictable. For example, if you are a farmer and you agree to sell corn in the fall, but then a natural disaster wipes out your crop, you will have to buy an offset contract. And if a natural disaster wipes out your crop, you’re probably not the only one, and the price of corn is likely to go much higher, resulting in a huge loss on top of the fact that you don’t have any corn to sell. Likewise, speculators are unable to anticipate all possible effects on supply and demand.
* Expiration: Futures contracts trading comes with an expiry date. Even if you are right in speculating that gold prices will rise, you could end up with a bad trade if the future ends before that point.
How to trade futures contracts
Getting started with futures trading requires that you open a new account with a broker that supports the markets you want to trade. Many online stock brokers also offer futures trading.
To get into the futures markets, though, brokers may ask more in-depth questions than they would when you opened a standard stock brokerage account. Questions may include details about your investment experience, income and net worth, all designed to help the broker decide how much leverage they are willing to allow. Futures contracts can be bought at very high leverage if the broker deems it suitable for him and you.
Fees may vary from broker to broker. Make sure to ask around to ensure you find the best broker for you based on price and services.
Once you open your account, you can then select the futures contracts you wish to buy or sell. For example, if you want to bet that the price of gold will rise by the end of the year, you can buy the December gold futures contract.
Your broker will determine the initial margin for the contract, which is the percentage of the contractual value that you need to provide in cash. If the contract value is $190,000 and the initial margin is 10%, you will need to provide $19,000 in cash.
At the end of each trading day, your position is marked in the market. This means that the broker determines the value of the position and adds or deducts this amount as cash in your account. If the $190,000 contract drops to $189,000, you will see $1,000 deducted from your account.
If the liquidity in your position is less than the broker’s margin requirement, you will be required to bring more cash into the account to meet the maintenance margin.
To avoid a physical delivery of the underlying asset, you will most likely need to close your position before expiration. Some brokers have mechanisms to do this automatically if you want to hold your position until it expires. Once you make your first futures trade, you can repeat it, hopefully with great success.
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