What is Futures Trading and How to Trade Futures?

Many retail investors in the market use long-term strategies and a minimal set of assets, usually limiting themselves to a few stocks, bonds, and one or two foreign currencies. However, stock exchanges offer traders many more instruments. In particular, the proficient use of derivatives traded on the futures market makes it possible to make substantial profits even from short-term market fluctuations. Most retail investors do not work with futures contracts, simply because they consider them extremely complicated and do not know how to trade futures. So today, we will learn the basics of futures trading, including its advantages and risks.

What You Need to Know About Futures Trading

This type of activity is considered one of the most promising areas of trading. The biggest growth over the last 20 years is observed in this sphere. Futures means a contract for the future purchase or sale of a specific asset. It is specified on what date it will take place. The subject of the contract may be:

• securities;
• commodities;
• currency;
• interest rates and other types of assets.

Trading futures may seem too risky an undertaking. However, these fears can be exaggerated. All trading involves an element of risk because it can make or break your business. With the right approach, you will make profitable trades, which will lead to profits.

How does it work? For example, you are selling wheat, and at the moment the price per 1 ton is $100. But according to forecasts, a high harvest is expected. In such a situation there must be a large volume of supply on the market, which will lead to a fall in prices. To get a good profit you agree to the delivery of wheat for 100 dollars. The contract necessarily specifies the delivery date. Suppose then the price of a ton of wheat drops to $50. But the buyer will still buy it from you at the previously established price. As a result, you are at a serious profit.

Let us present an opposite picture. You make a futures contract, but the year turns out to be a bad harvest, and the price of wheat explodes to $150. But you are obliged to sell it for $100, which turns out to be a lost profit.

Futures trading is a process where you act as a seller or a buyer. In addition to grains, trading in gas, oil, gold, gasoline, and currencies is widespread. In this way, you can make money on a variety of assets.

Why Use Futures Trading

As we have mentioned, a future is a standardized exchange-traded futures contract that obligates parties to buy/sell an asset at a fixed price in the future. There are several key features of futures trading:

• The price of the underlying asset is fixed at the time of the contract;
• It is not necessary to have the entire amount or quantity of an asset in your account at the time the contract is concluded. The collateral, which is usually several times less than the actual contract volume, is sufficient;
• The futures price differs from the spot price of the underlying asset. For contracts with different maturities, the difference in these prices is also different.

This gives rise to several variants of using futures contracts.

Hedging

Buying futures to hedge risks is the investor's insurance against unfavorable changes in the price of the underlying asset. This approach implies opening positions in two opposite directions so that a loss on one of them is compensated by a profit on the other.

Let us explain by example. An investor owns 1000 shares which are bought in line with the "buy and hold" strategy. The investor is not going to sell the assets, even during a crisis, but they want to protect the portfolio against a decrease in the price of the shares. To hedge the portfolio, they need to sell 10 futures contracts for the shares (the number of shares in the contract is 100; 10 futures will give an equivalent of 1,000 shares). As a result, when the quotes decline, the investor will regularly receive income in the form of a variation margin, which will compensate for the decline in the value of the shares. When the downward movement ends, the investor will close the futures position. The profits on the account will fully offset the losses. The spot position will remain the same.

Another less obvious option for hedging. The investor is sure that the price of shares has bottomed out today, and the best moment to buy them has arrived. However, the investor does not have enough money to pay for 1000 shares at the moment, but they are sure that they will appear in two months. By that time, the price of the securities may grow considerably, and the purchase will not be as profitable. To get the shares at a better price, an investor buys 10 futures contracts (they need to have the sum of the security on the account) with an expiration time closest to the estimated time of availability of funds. Upon completion of the contract, the investor pays for 1,000 shares at the price specified in the contract. But even if they sell the contract before the expiration time, the accrued variation margin on the futures will fully compensate for buying the shares at a higher price.

Speculation

Since the guarantee on the futures is substantially lower than the value of the corresponding volume of the underlying asset, it offers great opportunities for speculative profit.

Transactions in futures are popular because of the high liquidity of such assets. Traders may also trade based on large leverage. In this case, profit is gained due to the difference between the purchase and sale price.

Such a strategy has huge potential and allows for earning good money in a minimum period of time. An additional advantage is the commission rate, in this case, it will be less than on the stock market.

Another option for making profits is short selling. Experienced investors who know how to short futures have an excellent opportunity to profit from falling quotes.

Please note that profits from futures transactions do not coincide with changes in the price of the underlying asset. This is due to contract pricing, which takes into account long-term risks in addition to the value of the underlying asset. But this difference is insignificant; it is bigger for long-term contracts than for short-term ones.

Arbitrage

Futures contracts can be used for arbitrage operations:

• on spreads between different stocks (common and preferred) of the same issuer;
• on spreads between futures prices with different expiration dates.

In the first case, an investor buys a future for one stock (for example, common stock) and sells a contract with the same expiration date for another stock. In the second case, an investor buys, for example, a near future and sells a far future. On the spot market, arbitrage transactions are considered virtually risk-free, but the returns are small. On the futures market, because of the use of collateral, the rate of return increases substantially.

Thus, trading in futures can be extremely profitable. Just like in margin trading, the profitability that an investor receives is practically unlimited. In addition, experienced market participants are aware of additional income options.

However, since trading with collateral is a full analog of margin trading, risks increase significantly. In fact, the potential loss of a trader, in this case, is also not limited in any way.

How to Trade Futures – a Step-by-Step Guide

Most newcomers to the financial markets and even many experienced private investors do not work with futures, because they do not know how to start trading on the futures market correctly. However, there is nothing complicated about it. To trade you need:

• Choose a broker. As far as futures trading is carried out only on the stock exchange, you will have to choose a broker, which will provide you access to the futures market. You should be guided by the same criteria as when choosing a stock market broker. If a broker gives you access to other derivatives markets, such as the U.S. market, this is an additional advantage;
• Open a brokerage account;
• Deposit the planned amount in the account for futures trading.

If a broker offers several options for trading platforms, choose the most appropriate one. To estimate the advantages of this or that terminal, you can try each of them on a demo account.

• Choose contracts for trading. Which futures to trade depends on several factors: investor's preferences, goals, chosen strategies, market activity, and so on. For example, the decision of which futures are best to trade for hedging is made based on the structure of the portfolio. At the same time for speculative operations, the most liquid contracts are preferable.
• Wait for a signal to enter the market and place an order. In practice, this step in trading in futures does not differ much from transactions in any other market, for example, stock or currency markets. What differs is the analysis tools (technical analysis is more common for futures) and the approach to capital management and risk management.

After the execution of the order, one monitors the open position (if early liquidation is planned) or waits for the expiration time with automatic calculation.

Advantages of Futures Trading

Although it is possible to trade not only futures but also ordinary shares, promissory notes offer additional advantages. The experience of forex trading may have accustomed the trader to expensive leverage. With futures, the opposite is true.

The trader who buys stocks must pay for the securities. If the necessary amount is not available, the broker is ready to provide it. But the trader will have to pay the debt with interest.

If the futures are bought, the trader does not have to give the money. In fact, we are talking about the arrangements, so you will only need to provide collateral. Typically, the amount of collateral is 10% of the transaction amount.

Another advantage is saving on transactions. The stock market allows you to buy stocks, but you also have to cooperate with a depositary who will keep information about the ownership of the securities.

Futures are not stocks. You don't have to pay the depositary to hold them because it's a matter of arrangements.

Specifics of Futures on Different Exchanges

There are many stock exchanges in the world. The rules of trading may be different. For example, on the American stock exchanges, you can trade futures on cryptocurrencies. Moreover, the following are available:

• Stock futures;
• Futures on indices, most focus on systemically important companies;
• Futures on market volatility.

One of the features of the future is standardization. In fact, the seller and the buyer need to agree on the price of the contract, as well as the terms. The other points are already predetermined.

In practice, the price depends on the market, the date - on the exchange. In most cases, the trader decides whether they agree or not. If they agree, they can buy the futures immediately. Otherwise, you should wait for a more interesting offer.

Risks Involved in Futures Trading

There are risks of losing money in trading. There is no guarantee that you will be able to make money in the future. A competent strategy will only increase the probability of placing profitable trades. But many factors are not always possible to take into account.

For example, everything says in favor of the growth or relative stability of the asset value, and it promptly falls in price in a month. You have concluded a contract based on available forecasts and suffered losses.

In transactions with the use of leverage, there is a risk of not only losing the invested funds but also of being in debt to the broker. So such contracts must be concluded very carefully. They should not be used by beginners.

Of course, the chance to make a mistake is present, especially if the trader is inexperienced. That's why it's better to make a mistake losing small amounts. Also, disregarding training materials can lead to unsuccessful trades. By enriching your knowledge base, the trader becomes armed with useful information that can be used in trading.

Also, be sure to deal with reliable brokers. Don't fall for the companies offering you a 100% guarantee of profit. Trade on reliable and trustworthy platforms.

About AdroFx

Established in 2018, AdroFx is known for its high technology and its ability to deliver high-quality brokerage services in more than 200 countries around the world.  AdroFx makes every effort to keep its customers satisfied and to meet all the trading needs of any trader. With the five types of trading accounts, we have all it takes to fit any traders` needs and styles. The company provides access to 115+ trading instruments, including currencies, metals, stocks, and cryptocurrencies, which make it possible to make the most out of trading on the financial markets. Considering all the above, AdroFx is the perfect variant for anyone who doesn't settle for less than the best.