Future contracts allow two parties to trade assets at a fixed future date and at a set price. These parameters remain fixed regardless of what happens in the market.
Through this article you will be able to learn future trading, its types, advantages, and disadvantages associated with it.
Table of Contents
- What are futures in trading?
- Types of futures contracts
- How to buy futures?
- How to trade futures?
- Pros and Cons of Future Trading
What are futures in trading?
Futures in trading are derivatives financial contracts that allow parties to buy or sell assets at a predetermined future date and set price. Buyers and sellers will have to trade the underlying asset at the set price.
These assets can be any financial instrument or physical commodity. The predetermined price to buy and sell the asset is called ‘forward price’. The time set in the future for delivery and payment is called ‘delivery date’. Since futures are the function of underlying assets, these are derivative products.
Buyers and sellers are cannot change these parameters regardless of the current market conditions at the expiration date.
Types of Futures Contracts
Futures or futures contracts come with expiration dates (mostly in months) and set prices called upfront. Through futures, traders can lock in the price of underlying contracts. The following are different types of futures contracts:
- Commodity futures: natural gas, crude oil, corn, wheat, etc.
- Stock index futures: S&P 500 Index
- Currency futures: Euro and British pound
- Precious metal futures: Gold and silver
- U.S. Treasury futures: bonds and other products
How to buy futures?
To buy future contracts, you will first need to place an order with the broker. You will need to specify the details of the contract, including expiry month, contract size and scrip. After doing this, you will need to give the margin money to your broker. The broker can get in touch with the exchange to find a seller or a buyer for your future contracts.
Uses of Futures Contracts
- The initial aim of using futures contracts was mitigation of price risk and exchange rate movements. Parties could fix prices and dates in advance for future transactions. This benefited parties to receive payment in foreign currency in the future. It acts as a security against unfavourable currency movement until the payment is received.
- Future contracts give scope for speculation. Any trader who can predict the asset price can enter into a contract to buy or sell that asset in the future for a profit. If the trader profits from this contract, the underlying commodity would have been saved at the time of surplus and is sold during need. Consumers get a favourable distribution of commodities over the course of time.
- Futures are also used for hedging the price movement of an underlying asset. This prevents losses in case of unfavourable price changes.
Trading in Futures
To learn how to trade in futures, investors should understand certain key points about futures contracts. This is to determine the position size and to manage risk. These include the following points:
- Contract Size: Before you start trading in futures, you should know about this term. A contract is a deliverable quality of an asset such as stock or financial instruments that underlie the futures contract.
- Future Value: Cash value of an underlying asset helps in deriving the future value. To calculate the value of a future, you can do that by multiplying the contract size with the current price.
- Tick Size: It is the minimum change in the price of a futures contract. Futures markets have a tick size specific to the instrument. A $1 minimum tick size is known as “points”.
How to Start Futures Trading?
If you want to learn how to trade futures, you can start with the following steps:
- Opening an account: First of all, you will have to open an account with a futures market broker. You will be asked about your experience in investing, income and net worth. These will help in determining the risk that your broker will allow you to take in terms of margin and positions.
- Paper trading account: You can start your trading journey by practising trading using “paper money”. This will prevent you from losing any actual money in your first trade. You should learn about futures markets, leverage and commissions interact with your portfolio. Virtual accounts are better for those who have just started out. Experienced investors also use paper trading accounts for testing new strategies.
- Developing a plan for trading futures: A trader should prepare a plan that outlines strategies for entry and exit along with risk management rules. A futures trading plan based on fundamental analysis may generate buy or sell signals based on reports. As an experienced trader, you can use both technical and fundamental analysis for futures trading plans.
Pros and Cons of Futures Trading
- Leverage: Futures are traded on margin due to which investors have control over larger positions with a small initial outlay. Traders can lose more than their initial margin if the asset’s price moves in an unfavourable unintended direction.
- Diversification: Investors can trade futures on anything from the stock index to apple juice. This helps traders in diversifying their investment portfolios across multiple asset classes.
- After-Hours Trading: Futures contracts allow traders to seize opportunities all day long. A trader can go for long futures contracts on the Nasdaq 100 Index in case mega-cap technology stocks report better than the expected earnings post-market close.
- Hedging: Futures protect traders against unrealized profits or losses. Traders can take cost-effective hedge against the broader market and individual commodities.
- Expiry Dates: Futures contracts come with expiry dates and traders must monitor them. When the future contract approaches its expiry date, its price will fluctuate and may lose value thus, becoming worthless. Investors need to frequently roll forward futures contracts to a longer-dated one.
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