What is Futures Trading & How It Works

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What is Futures Trading?

To begin, we jump right into the question at hand of exactly what is futures trading. To keep it simple, futures trading refers to a standardized contract between two parties to buy or sell an asset at a predetermined price and date in the future.

The asset can be a commodity, currency, or financial instrument, and the contract specifies the quantity and quality of the asset.

One of the primary reasons why futures trading is popular among investors is its ability to manage risk. By buying or selling futures contracts, traders can lock in prices for the underlying asset and avoid price fluctuations.

For example, a farmer may sell futures contracts for his crop in advance, thereby protecting himself against a drop in the market price at the time of harvest.

How Futures Trading Works

Now that we have answered the question of what is futures trading, let’s delve deeper into how it works.

In a futures contract, the buyer agrees to purchase the underlying asset at a specified price and date in the future, while the seller agrees to deliver the asset at that price and date.

The price of the futures contract is determined by the market forces of supply and demand, and it can fluctuate as the expectations of traders change.

Futures trading takes place on exchanges, where traders can buy and sell contracts with each other. The exchanges act as intermediaries, ensuring that both parties meet their obligations and facilitating the trading process.

Traders can close out their positions at any time before the delivery date, either by selling their contracts to another trader or by offsetting their position with an opposite trade.

Types of Futures Contracts

Anyone looking for a comprehensive answer to the question, ‘What is futures trading?’ will soon realize that futures trading encompasses a wide range of markets and assets.

Understanding the different types of futures contracts can provide insight into the various investment opportunities available, as well as the risks and rewards associated with each market.

The following are the most renowned types of futures contracts:

Commodity Futures: Futures contracts for physical goods, such as agricultural products, energy, metals, and livestock.
Financial Futures: Futures contracts for financial instruments, such as bonds, stocks, and options.
Currency Futures: Futures contracts for the exchange of one currency for another at a predetermined price and date in the future.
Index Futures: Futures contracts based on a stock market index, representing a basket of underlying stocks.
Interest Rate Futures: Futures contracts based on the value of an underlying interest rate, such as the Federal Funds rate or LIBOR.

Advantages of Futures Trading

Having comprehensively dealt with the question ‘What is futures trading?’ we now explore each of its strengths, that make investing in futures such an appealing approach to market players.

The following are some core advantages that are typically associated with futures trading:

Leverage

Through futures trading, investors acquire the ability to control a large position in their portfolio with a relatively small amount of capital. They may also benefit from exposure to assets without actually having to hold those assets at all.
Hedging

Futures trading provides a way for traders to manage risk by locking in prices for an underlying asset, protecting against price fluctuations, and ensuring a predictable outcome.
Diversification

Futures trading allows investors to spread their investments across different markets and assets, reducing overall portfolio risk and potentially increasing returns through exposure to a wider range of opportunities.
Access to Global Markets

Investors dealing in futures hold access to markets around the world, with exposure to diverse economic and political conditions and potentially reducing risk through geographic diversification.
Liquidity

Futures trading offers a highly liquid market where traders can quickly buy and sell contracts, ensuring that prices reflect the true supply and demand for the underlying asset and providing flexibility for traders to enter and exit positions as needed.

Risks of Futures Trading

When considering investing in futures, while the strengths may seem compelling, one must not be blindsided and should pay attention to the risks associated with the investment class. The following are some of the risks that futures traders often face:

High Leverage

Futures trading allows traders to control large positions with relatively small amounts of capital, but this also means that even small movements in price can lead to large losses, making it a high-risk activity.
Volatility

Futures markets are often subject to sudden and dramatic swings in price due to changes in supply and demand, political events, or other factors. Traders must be able to handle the psychological pressure of these market movements.
Counterparty Risk

Futures trading involves the risk that the other party to the trade may default on their obligations, leading to losses. This risk can be mitigated by trading on regulated exchanges with strict margin requirements and clearing mechanisms.
Liquidity Risk

Futures markets can become illiquid, particularly in times of market stress or during periods of low trading volume. This can make it difficult to execute trades at desired prices, potentially exacerbating losses.
Margin Calls

Futures trading requires traders to post a margin, or a deposit, to cover potential losses. If losses exceed the margin posted, traders may be subject to margin calls, requiring additional funds to cover losses.

How to Start Futures Trading

As with anything in the financial arena, the first step in starting futures trading would be educating one’s self regarding the intricacies of the market they are getting into. This will involve learning about the different types of futures and knowing what are stock futures

When one has completed the educational aspect and is ready to move on, the first step to take would be to open a brokerage account with a reputable firm that offers futures trading and deposit the required funds.

As you progress, you would find the need to develop a trading strategy, including risk management and money management techniques. At this point, begin trading by placing orders for futures contracts through your brokerage account.

It is important to understand the mechanics of trading and to stay informed about the markets and economic events that can impact prices

Common Strategies for Futures Trading

Traders that have taken the step toward executing a futures trading approach may use one or more of these strategies depending on their trading style, risk tolerance, and market outlook.

There are several common strategies for futures trading that traders use to try and achieve their desired outcomes. Here are a few examples:

Day Trading

A short-term trading strategy that involves opening and closing positions within the same trading day. Day trading remains a highly popular form of trading even beyond futures.
Swing Trading

A medium-term trading strategy involves holding positions for several days to a few weeks in anticipation of a price swing in the market.
Position Trading

A long-term trading strategy involves holding positions for weeks, months, or even years in anticipation of a significant price move in the market.
Spear Trading

A strategy that involves trading the price difference between two related futures contracts to potentially profit from the spread between them.

Buying vs Selling Futures

The difference between buying and selling futures is that when you buy a futures contract, you are agreeing to purchase an underlying asset at a predetermined price and time in the future.

This means that you are betting on the price of the underlying asset to go up, and you will make a profit if it does.

On the other hand, when you sell a futures contract, you are agreeing to sell an underlying asset at a predetermined price and time in the future. This means that you are betting on the price of the underlying asset to go down, and you will make a profit if it does.

In both cases, there is a potential for profit or loss, depending on the movement of the underlying asset’s price.

Futures vs Options: What are the Differences

Feature	Futures	Options
Definition	A standardized contract to buy or sell an underlying asset at a future date and a predetermined price	A contract that gives the holder the right (but not the obligation) to buy or sell an underlying asset at a future date and a predetermined price
Obligation	Obligates both buyer and seller to fulfill the contract at expiration	Gives the holder the right, but not the obligation, to buy or sell the underlying asset
Underlying Asset	Typically a commodity, currency, stock index, or interest rate	Can be a wide range of assets, including stocks, bonds, commodities, and currencies
Market Accessibility	Typically traded on an exchange and accessible to anyone with a brokerage account	Traded on an exchange or over-the-counter, and require approval for options trading
Risk	High risk due to the obligation to fulfill the contract	Lower risk due to the right, but not the obligation, to buy or sell the underlying asset
Potential Profit	Potentially unlimited profit if the market moves in your favor	Limited profit potential, but can be less risky due to the right to choose whether to exercise the option or not
Potential Loss	Potentially unlimited loss if the market moves against you	Limited loss potential to the premium paid for the option contract

Conclusion

In conclusion, futures trading can be a powerful tool for investors and traders looking to manage risk, diversify their portfolios, and potentially profit from price movements in the financial markets.

However, as we have seen, it is important to understand the unique features and risks of futures trading, including leverage, counterparty risk, and the potential for margin calls.

In this article, we have attempted to answer the question “What is futures trading?” and provide a comprehensive overview of the different types of futures contracts, trading strategies, and potential benefits and drawbacks.

By educating one’s self on futures trading and developing a well-informed trading plan, investors and traders can navigate this complex and dynamic market with confidence and success.

What is Futures Trading & How It Works