A Basic Guide to Futures Trading

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Investors may be looking to diversify their portfolios. Doing so reduces any risk they are taking on. However, they should consider all investment options when making this move. 

Futures trading is one option that is often overlooked, but it should not be. This investment option comes with benefits every person should know. For instance, this type of trading comes with lower costs. Corporate entities find they can lock in current prices, and individual investors benefit from price movements. 

Nevertheless, there are risks associated with futures trading. While profits are high, losses are as well. Before investing in futures, a person must have a thorough understanding of what they are, how they work, and more. 

What are Futures?

A future is a financial contract based on an underlying asset or group of assets. The asset or assets determine the value of the contract. When an investor purchases futures, they are agreeing to buy or sell this asset on a specific date at a predetermined price. The current market price doesn’t come into play when this date arrives.

As a result, the investor could make a purchase and have the price increases significantly between the date of purchase and the contract end date. If the price increases significantly, they make a large profit. On the other hand, if the price drops significantly, the investor takes a major loss. 

Futures TradingA Basic Guide to Futures Trading

Futures trading allows an investor to invest only a portion of the assets’ value. Debt or borrowed money can be used to purchase the contracts thanks to leverage. This allows the investor to increase their returns, but it also means their losses could quickly escalate. Before trading futures, an investor must possess an account with an approved brokerage. 

The investor puts up a fraction of the total value of the contract. This is referred to as the initial margin and is often between three and ten percent of the total value of the contract. The broker or trading provider puts up the rest of the money. 

The futures exchange determines the initial margin. However, investors must have a maintenance margin, which is nothing more than funds in their brokerage account. The minimum amount tends to run between 50 and 75 percent of the initial margin of the investment the individual wishes to purchase. 

If the maintenance margin drops below this amount, a margin call is issued. The investor must then deposit additional money into the account to return the total to the initial margin level. 

Hedgers and speculators often invest in futures contracts. Hedgers do so to lock in current prices of raw materials, and these hedgers are institutional investors. Speculators, in contrast, are individuals looking to invest in futures. They do so to benefit from price swings and have no interest in the raw materials behind the contract. 

How Futures Differ from Options

With a futures contract, the investor is locked in until the expiry data. However, holders may close their position before this date if they choose. This isn’t the case with options contracts.

When a person buys an options contract, the investor may but or sell shares at a predetermined price whenever they desire. They don’t need to wait until the expiry date.

Asset Classes Seen in Futures Trading

Standard asset classes in futures trading include financial futures, commodities, and currencies. Commodity futures include things such as energy and metals futures. Agriculture and grain futures are also examples of commodities futures. Index contracts and interest rates contracts are financial futures, while currency futures are those that provide exposure to exchange rates. 

Futures Traders

Futures traders fall under two categories. Institutional investors are known as hedgers. They function to prevent losses from increasing raw material prices. They need these materials to continue operations and use futures contracts to protect themselves from rising prices.

Sellers benefit by locking in high prices when there is worry that the prices will drop in the coming months. They aren’t looking to make a profit as much as they are trying to secure prices for these materials. 

Speculators, in contrast, enter the futures market hoping to make large profits. They have no desire to get the raw materials. These individuals must adhere to the maintenance margin, which is based on volatility. These individuals are only in the market for the cash. 

Futures Trading Strategies

There are many futures trading strategies an investor may use. However, before using any of these strategies, an investor must thoroughly understand the market. In addition, they need to choose one strategy and stick with it.

Many investors use a directional strategy, but this is only one of several available. Short-term investors, however, might prefer liquid contracts, while spread treading is used by investors who have more experience. 

Benefits of Futures Trading

Futures trading allows an investor to diversify their portfolio. They can use leverage to generate higher profits and margin requirements remain the same, whether an investor takes a long or short position.

Profits from futures trading come with a lower tax rate than seen with stock trading, and a futures contract allows a hedger to lock in current prices. Furthermore, these investments come with lower transaction costs. 

Risks of Futures Trading

Investors must know of the high risks that come with futures trading. A person must spend more time learning how to invest in futures than they do in stocks and other opportunities. This helps to avoid common mistakes many futures traders make. Significant losses are common in futures trading, and a hedger might miss out on price drops when they lock in at the current price with the help of a futures contract. 

Before investing in futures, spend time learning the processes associated with this type of investment. This includes leverage, obligations, and transaction fees. Furthermore, the investor must find a reputable broker and educate themselves on the underlying assets used in futures contracts.

While brokers share this information freely, investors need to ask questions before choosing which futures contracts to invest in. Technical analysis is needed, and the broker can help with this. Start small and increase futures investments slowly. Doing so helps to minimize the risks an investor is taking on, which must be a consideration with any investment today.