Nowadays, when it comes to making online investments, there are a variety of options out there. One such option is learning how to trade futures. Trading futures can be potentially rewarding, especially if you find opportunities in rising and falling markets. However, it is certainly not for everyone, especially those who are risk-averse. In this article, we discuss what the basics are, and how someone can get started.
What is a futures contract?
A futures contract is a legal agreement between parties to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. They are a type of derivative trading, where they derive their value from another financial item’s price movement. Futures contracts are often used by businesses and traders to hedge risk or speculate on the future of a commodity or market. These commodities can include soybeans, coffee, individual stocks, oils, exchange-traded funds, and more.
Essentially, a futures contract is similar to an options contract. However, unlike options that become worthless when they expire, the buyer of a futures contract is obligated to buy and receive the underlying asset when the contract expires. On the other hand, the seller must provide and deliver the underlying asset at the delivery date.
Futures contracts are often standardized regarding quality and quantity, which makes them able to be traded on a futures exchange such as the CME Group. This is a marketplace where commodities such as futures, index futures, and options on futures are traded. In Denmark, futures contracts are considered red products as it comes with high complexity and risk. As such, they are regulated by the Danish Financial Supervisory Authority (FSA). Retail investors also need to register with a broker to begin trading.
A short history of futures
What could be said as the first futures trading exchange was the Dojima Rice Exchange. Established in 1730 in Japan, the purpose was to trade rice futures. England started futures trading sometime in the 16th century, but the London Metals and Market Exchange would only be established in 1877. The United States began trading futures in the mid-19th century, so farmers could sell their products (mainly grain) either for immediate or forward delivery. Other futures contracts in the US include corn, wheat, and soybeans. These agricultural commodities still account for the majority of trades conducted to this day.
The original purpose of these markets was to reduce risks for producers and wholesalers. Farmers got to be paid upfront, and the cash was used to carry them through the harvest. Wholesalers were also confident that they had a sufficient supply of the product at the set price when they needed it.
How do they work?
Futures contracts are derivates that lock the price and amount of a commodity. They are accessible for four different assets – stocks, currency pairs, indices, and commodities. The date set in the contract is called the expiry date. Futures contracts are a fantastic method of protecting against the possibility of large fluctuations in the market. For example, a food processor that cans corn may be worried about prices going up, meaning they have to pay the farmers more. To protect themselves against growing corn prices, they can buy enough corn futures contracts to cover the amount of corn needed. This is an example of hedging, which is one of two ways futures contracts can be used.
- Hedger and Hedging: By using a futures contract, producers and purchasers ensure they have a buyer and a satisfactory price. This method attempts to control commodity price risk and predict production costs. Essentially, hedging acts like an insurance policy to reduce the risk of adverse price movements. For instance, an oil producer may use futures contracts to lock their selling price, and then deliver the oil to buyers once it expires. Conversely, a manufacturing company that relies on oil may use futures contracts so they know in advance the price of oil, and that the oil will be delivered once the contract expires.
- Speculator and Speculating: Commodity prices often move in predictable patterns, so investors can use this opportunity to potentially make gains. Futures contracts are also liquid and can be bought and sold up til the expiry date. This feature is important if investors do not own the underlying commodity or do not want to. As such, they can either buy or sell futures to benefit from rising or falling markets. Before expiring, the investor will then buy or sell the contracts so that they do not have an obligation to the actual physical commodity.
Types of futures
There are a variety of different futures contracts, each corresponding to a different commodity or asset. Some of the most popular ones are included below:
- Agricultural futures: These were the original futures contract that could be found in markets like the Chicago Mercantile Exchange. Much like its name suggests, it includes grain, fibers (cotton), lumber, coffee, milk, sugar, as well as livestock.
- Energy futures: These feature the most common fuels such as crude oil, natural gas, gasoline, heating oil, and other petroleum products.
- Currency futures: Due to globalization, currency futures help to provide exposure to different fluctuating exchange and interest rates of currencies. Cryptocurrencies such as bitcoin and Ethereum are now also available to be traded.
- Financial futures: These contracts focus on trading on the value of an index or security. These include stock indexes and commodity indexes. There are even futures for the S&P 500 and Nasdaq indexes. Treasury bonds and other debt products are also included in this category.
- Metal futures: They trade in precious metals such as gold and silver, as well as more industrial metals like copper and steel.