Futures trading allows you to speculate or hedge on the future value of all types of assets, including stocks, bonds, and commodities. It offers much higher leverage than stock trading, with the potential for high returns at a high level of risk.

You can diversify your holdings if you know how the futures market works and how it could fit into your portfolio.

What is the future?

People typically mean “futures” when they use the term “futures” within the financial world. Futures contracts specify the terms of delivery or cash settlement for a specific asset, such as raw materials, stocks, or finished products, at a future date. Futures are derivatives because their value is derived from the underlying asset.

Contrary to stock options, the contract holder must settle the futures contract. This is the main difference between options and futures. Options give contract holders the right, but not the obligation, to pay the contract.

Futures can be very useful for business. You may want to lock in a price before harvesting corn if you have a farm. This can ensure a steady income throughout the year and prevent any unpleasant surprises in the event that the cost of corn drops. It also means that you will not benefit if corn prices skyrocket before harvest.

A futures contract can be bought or sold. You agree to pay the specified price at a specific date if you purchase the contract. When you sell a contractual agreement, you agree to deliver the asset at the price specified.

Understanding futures

Futures contracts are usually traded in a stock market, where the contract standards are set. The contracts are standard so that they can be freely traded between investors. This ensures that speculators do not end up physically receiving a tanker of oil.

Each contract represents a standard amount. Gold futures, for example, are traded in 100 troy-ounce contracts. If gold trades for $2,000 an ounce, then each contract has a value of $200,000. Each futures contract represents 100 barrels of oil, which is about 42 gallons. Corn is measured by bushels (which weigh about 56 pounds), and futures contracts have a standard of 5,000 bushels.

Futures contracts specify how trades will be settled by the parties to the agreement. The contract holder will either take delivery of the asset or pay the difference in cash between the market price and the contracted price.

Investors can easily speculate on future values of assets traded on the market with standard futures contracts. If investors believe that the oil prices will rise in the coming months, they may buy a contract with a duration of three months or longer. They can sell the contract easily when it is near the exercise date and hopefully make a profit.

Several parties use futures to hedge their position. A producer can use futures contracts to lock in the price of their products. An oil company, for example, might sell oil futures in order to guarantee a certain price on the output it produces each year.

A company can also hedge its market by buying futures for the commodities it consumes. An airline, for example, may purchase futures on jet fuel. This allows for predictable costs, even if jet fuel prices fluctuate.

If you have a diversified and large portfolio of stocks and wish to protect yourself from downside risks, futures are another way to hedge. You can sell a contract for futures on a stock index. If the stock market fell, then this position would gain in value.

The pros and cons of futures trading

Pros

• It’s easy to bet on the asset. Short-selling futures contracts are easier and give you access to more assets.
• Simple Pricing Futures Prices are based upon the current spot prices and adjusted to reflect the risk-free return rate until expiration and the cost of storing commodities that will physically be delivered to the buyer.
• Liquidity. The futures market is highly liquid, making it easy for investors and traders to enter or exit positions without incurring high transaction costs.
• Leverage. Trading in futures can offer greater leverage than standard stock brokerage accounts. With futures trading, you can get up to 20:1 more leverage than a standard stockbroker. With greater leverage comes greater risk.
• How to hedge your positions easily : A strategic futures position can protect you and your portfolio from downside risks.

Cons

• Sensitivity towards price fluctuations. In the event that your position moves in your favour, you might have to pay more money to cover your maintenance margin. This will prevent your broker from closing your position. When you are using a high level of leverage, you don’t need to see a big change in the asset to be forced to increase your margin. This can turn an investment that could be a big winner into one that is only mediocre at best.
• Futures traders are also exposed to the risk of an unpredictable future. If you are a farmer, and you agree to sell corn this fall, but a natural catastrophe wipes out the crop, then you will have to purchase an offset contract. If a natural disaster wiped out all of your corn, you are not alone. The price of corn would have likely increased, resulting in an additional loss. The same goes for speculators, who are not able to predict all possible impacts on demand and supply.
• Expiration. Contracts for futures have an expiration date. You could lose money even if your speculation were right, and gold prices would rise.

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Futures trading: How to Trade?

To get started with futures trading, you will need to open a brand new account with a broker who supports the markets that you wish to trade. Many online brokers offer futures trading.

They may ask you more detailed questions to gain access to the futures markets than they did when you first opened your stock brokerage account. The broker will ask you about how much money is needed to begin trading futures, your investment experience, your income and your net worth. This information helps them determine how much leverage to offer. The broker can allow you to buy futures contracts with high leverage.

Brokers charge different fees for buying and trading futures. Ask around for the best broker based on services and price.

After your account has been opened, you can choose the contract that you would like to buy in the future. If you’re betting on gold prices rising by the end of the year, for example, you can buy the December futures contract.

Your broker will decide the initial margin, which is usually the percentage of the contract value that you must pay in cash. If the contract value is $180,000, and the initial margin of 10% is required, you will need to pay $18,000 cash.

Your position is marked up to market at the end of each trading day. The broker will determine the value of your position and then add or subtract that amount from your account. If the $180,000 contract dropped to $179,000, you would see $1,000 taken out of your account.

If the equity of your position is below the broker’s maintenance margin, you will be required to add more money to your account.

If you want to avoid physical delivery, you must close the position before expiration. However, some brokers automatically close positions that are kept open until the expiration date.

After you have made your first trade in futures, you can repeat the process and achieve great success.