What Is Futures Trading?

Now popular among ordinary investors, these agreements affect the prices we pay for food, fuel, and most raw materials that support modern life. Investors can trade futures to speculate on, and potentially profit from, changes in the value of a wide range of underlying assets, including commodities, stocks, and bonds. Because interested parties can harness futures to speculate on the future prices of so many different assets, futures contracts can be used to help construct a highly diversified portfolio. On the other hand, investors should understand that futures trading can be fairly complex and it can lead to overleveraging.

1. Another draw is that some futures trades may qualify for preferential tax rates.
2. Now popular among ordinary investors, these agreements affect the prices we pay for food, fuel, and most raw materials that support modern life.
3. Futures trading is leveraged, allowing investors to trade more significant amounts of money than their original investment, which means they need less equity to enter the trade.
4. Whereas with other investing strategies, margin requirements for long and short positions differ, with futures contracts, the margin is the same for both without additional requirements.
5. Without prudent safeguards like stop-loss orders that trigger automatic sell-offs before additional losses and the self-discipline to avoid recklessly large gambles, futures traders can court ruin.
6. Say the S&P 500 index recently broke out to a new all-time high, and we want to fade the move, hoping to book profits on a retracement to the initial breakout area around $4,720.

Futures contracts can be an essential tool for hedging against price volatility. Companies can plan their budgets and protect potential profits against adverse price changes. Investors risk losing more than the initial margin amount because of the leverage used in futures. Futures are contracts to buy or sell a specific underlying asset at a future date. The underlying asset can be a commodity, a security, or other financial instrument. Futures trading requires the buyer to purchase or the seller to sell the underlying asset at the set price, whatever the market price, at the expiration date.

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However, it also means you won’t reap the benefits if the price of corn skyrockets before it’s time to harvest. Now that we’ve seen what futures are, let’s explore how they work by defining and illustrating some essential futures terms. Get stock recommendations, portfolio guidance, and more from The Motley Fool’s premium services. This form of socially responsible investing prioritizes good corporate behavior.

Futures and stock trading have certain things in common, but the former has additional considerations like leverage and also expiry dates. In this article, we’ll help you find out by taking a close look at what futures are and how they work. Investors should have a basic if not thorough understanding of how futures trading works before they begin. Knowing the benefits and drawbacks can spell the difference between success and loss. Just like any other strategy or trading method, there are some key benefits and drawbacks that you should be aware of before you start. These points are just as valuable if you’re a novice investor or if you’re a seasoned pro.

What Happens If Investors Hold a Futures Contract Until Expiration?

If the equity in your position falls below the broker’s margin requirements, you’ll be required to bring more cash to the account to meet the maintenance margin. That means the broker determines the value of the position and adds or deducts that amount in cash to your account. If the $180,000 contract fell to $179,000, you’d see $1,000 come out of your account. Your broker will determine your initial margin for the contract, which is usually a percentage of the contracted value you need to provide in cash.

Drawn by margin-fueled leverage allowing outsized gains (and losses), retail investors add liquidity while trying to profit from short-term fluctuations. A 2024 study by economists at the Commodity Futures Trading Commission (CFTC) concluded that, in general, “retail traders lose money in futures markets.” Futures trading is facilitated by futures exchanges, like the Chicago Mercantile Exchange (CME), and requires investors to have an approved brokerage account. When traders or companies enter a futures contract, it obliges them to sell or buy the underlying assets at a set price and date in the future. For example, profits in the airline industry can be heavily dependent on the price of fuel. To protect against a sudden surge in prices, an airline company can use a futures contract to lock in current prices, thus nullifying the impact of increasing fuel prices.

You may choose to go long or short, or you may decide to use calendar spreads. Whatever you choose, it’s always a good idea to plan your entry and exit strategies and basic risk management rules. Most futures contracts are traded through centralized exchanges like the Chicago Board of Trade and the Chicago Mercantile Exchange (CME). Many cryptocurrency brokers, such as Binance, offer perpetual futures—a contract without an expiry date—allowing traders not to worry about an expiry month. As futures are leveraged, investors don’t have to put in the entire equity amount to enter the trade.

Beyond the CFTC

They give uninterrupted exposure to the prices of the underlying assets to commodities like gold or oil, unlike stocks, where many other market factors are in play and affect the share prices. Similarly, a trader can take a long position, which means speculating the prices of underlying assets will go up and will trade above the original price at the contract expiry. If that happens, they will profit, and the futures contract will be sold at the current price and closed before expiration.

For traders, the settlement is in cash, while some businesses may opt for physical delivery. With standardized futures contracts, it’s easy for investors to speculate on the future value of any asset traded on the futures market. If a speculator thinks the price of oil will spike over the next few months, they can buy a futures contract for three months or more from the current date.

Due to the highly liquid nature of futures markets, traders can quickly move in and out of their open positions. Selling a futures contract can also be relatively easier than short-selling stocks. For hedgers, futures contracts offer the possibility to lock in current prices of commodities they know they need in large amounts for future production or manufacturing of their products. Trading futures instead of stocks provides the advantage of high leverage, allowing investors to control assets with a small https://forexanalytics.info/ amount of capital. Additionally, futures markets are almost always open, offering flexibility to trade outside traditional market hours and respond quickly to global events.

The CFTC establishes rules, monitors market activity, and enforces regulations to prevent manipulation and ensure a fair and transparent marketplace. These speculative powerhouses forex prediction software trade their capital with algorithmic trading, often at lightning speed. Prop shops leverage sophisticated technologies and quantitative strategies for fleeting market inefficiency.

Short-term traders often work with front-month contracts, while long-term investors might look further out. Another consideration is that if an investor trades multiple futures contracts, it can be difficult for them to monitor their respective expiry dates. As these contracts approach these dates, their value can change sharply, potentially losing their worth. Futures trading is a way to speculate on or hedge against the future value of all kinds of assets, including stocks, bonds, and commodities. Trading futures can provide much more leverage than trading stocks, offering the possibility for very high returns but with very high levels of risk.

Whereas the futures exchange is the one setting the initial margin, your broker will require you to have additional funds in your account, called maintenance margin. The minimum amount should be on your account at any given time, usually between 50% to 75% of the initial margin. More advanced traders may want a platform that provides application programming interface (API) access to allow algorithmic trading functionality. Active traders should select a futures platform with a mobile trading app that lets them execute trades and manage positions on the go.

For example, a trader could go long S&P futures and short NASDAQ futures if they think the S&P is undervalued next to the NASDAQ. The fact that the markets are global adds further complexity since international coordination is necessary to prevent traders from exploiting regulatory gaps. On the other side, a company might hedge the market for commodities they consume. That provides predictable expenses even if the price of jet fuel fluctuates. Unlike stock options, futures require the contract holder to settle the contract. Options give the contract holder the right — but not the obligation — to settle the contract.

Regulations aim to smooth violent price swings, but balancing market fluidity remains tricky. The outsized market footprint of large institutional investors like hedge funds, along with ultrafast computerized trading, injects systemic fragility. There are several factors that contribute to the complexity of the futures market, including the use of leverage and expiration dates. Because these contracts make use of margin, investors can easily become overleveraged, which can potentially lead to significant losses and/or substantial volatility in one’s portfolio. A futures trading plan will revolve around your specific trading strategy. That is, your plan should factor in if you’re a technical analyst or if you use fundamental analysis in your trading.