Futures trading is the buying and selling of an asset at a preset price for delivery on a preset date. There are many different types of futures, from oil to corn to foreign currencies, but they all follow the same basic steps: first, you need a product and a futures contract to purchase that product at a set date and price. You then trade that futures contract with other traders who have done the same thing.
What is a futures contract?
Futures contracts allow traders to be involved in asset price movements without taking physical delivery of the commodity or financial instrument. This process is done through standardised procedures to offset risk and eliminate the need for storage, allowing retailers and producers to remove tie-up capital from inventories and put it into another investment that can turn a profit. These transactions occur every day on exchanges around the world, and as such, we should not overlook those looking to take part in price movements across commodities and markets.
Futures contracts are traded on an exchange between two parties: a buyer and a seller. The buyer agrees to purchase an underlying good at a set time (the futures contract expiry) while the seller agrees to supply it. In the expiry process, the buyer physically takes ownership of the good while the seller is obligated to deliver or receive cash for their part in the transaction.
To offset this risk of non-delivery by either party, futures contracts have a daily settlement price upon which both parties must agree before trading can begin. To ensure profits or losses stay consistent with expectations, traders who wish to make high-volume trades should consider using standardised contracts instead; these contracts have a specific price, with no settlement.
Futures contracts can vary from a few months to several years, but most high-volume traders utilise monthly and quarterly expiries. These higher volume periods allow for better market depth and more opportunities to sell short or buy low.
Critical characteristics of futures trading
The main issue with futures trading is that it offers negligible diversification because one market can affect everything else, meaning no matter what happens in the world, your position in any given futures contract can go up or down in value.
That doesn’t mean you shouldn’t trade futures, but it does mean that if you are looking for a safe investment to make over several years, futures probably aren’t the best option for your portfolio. Futures are not havens from market volatility but provide an opportunity to take advantage of price movements.
Futures trading is a safe way to make money if done correctly, but there are many different futures markets, and each one must be studied before entering into any investment. Futures contracts are not havens from market volatility because they can go up or down in value depending on what happens. By using them well, investors can take advantage of price movements that other people don’t think will happen.
What are the risks associated with futures trading?
You can buy or sell almost anything as long as someone else is on the opposite side of your trade. For this reason, futures contracts are considered low-risk investments because there is always somebody who has bet against what will happen. If something goes wrong, you lose money but so does the counterparty.
You are taking on some risk, but not as much as if you traded stocks that are considered to be riskier. Futures are also limited in the number of money traders can lose since there is always a counterparty. If stock prices go down, they may never recover, and you will lose all of your money. With futures, even if prices go against you once they reach the delivery date, you have an agreement with your counterparty to buy or sell at an agreed price, so you don’t lose everything.
To summarise, futures trading is a great way to diversify stock portfolios with low-risk income generation. However, it does require study and expertise, so new investors interested in future investment should use a reputable online broker before making any financial commitments. Try your hand at online trading by using a demo account before you start trading with real money.