The futures market is where traders and investors can buy or sell their futures contracts. A few of the most popular futures markets include:
- Chicago Mercantile Exchange.
- Chicago Board of Trade.
- New York Mercantile.
- Kansas City Board of Trade.
- Minneapolis Grain Exchange.
Futures markets will offer a wide variety of investment opportunities, such as:
- Currency pairs.
Often, the commodities will include beef, grain, crude oil, metals, and corn.
What Is a Futures Contract?
A futures contract is an agreement made between parties to buy or sell an asset at a future date for the price set when the transaction is made. They are essentially standardized agreements that trade on an exchange. When you buy a futures contract, you agree to a date on which you will buy the set amount of commodities or securities. The seller agrees to provide you with the securities and commodities on that date.
Investors, speculators, and companies all take part in the futures market. Investors and speculators look to make money off the deal, while companies are typically looking to supply a product.
What Is Investing in Futures?
Many people buy futures contracts to avoid the wild price fluctuations that might lie ahead. For example, a transportation company might want to lock in its fuel rates to avoid the possibility of an unexpected increase. To reduce the risk of increased costs, the business can sign a futures agreement promising to buy a set amount of fuel at a future date for the price set in the contract. Fuel distributors might agree to the contracts to prevent the risk of an unexpected decline in prices and to ensure they maintain a steady market.
It is important to note that not all companies in the futures market wish to exchange their products in the future. These are often the investors and speculators who are out to try to make a profit off the price changes in the contract. For example, if they invest in a futures contract for fuel, and the price goes up, they can then sell the fuel for the increased price and profit off the buy.
How Are Futures Different Than Traditional Stocks?
The primary difference between traditional stock and futures is that with traditional stock, trading happens in the present, and investors buy and sell shares immediately. With futures, you must estimate the price the stock will trade at in the future. Once you have agreed to buy or sell that stock, you have locked in that price.
Risks of Futures Trading
One of the most common risks of futures tradings has to do with leverage and margins. With futures, the rules for leverages and margins are much more liberal than for other securities. Some brokers might allow you to leverage 10:1 or in some cases 20:1, which is significantly higher than you could obtain in a traditional stock exchange.
When it comes to investing, the greater the leverage, the greater the possible gains as well as losses. Something as small as a 5% change with a leverage of 10:1 could result in a potential loss of 50% of the investment. A higher volatility means investors and speculators need to avoid overexposing themselves.
How to Trade Futures
Getting started trading futures can be as simple as opening an account with a broker who is experienced in futures trading. That broker will ask you questions about how you like to invest, your experience, your income, your net worth, and how much risk you like to take when investing.
When choosing a futures trader, it is important to note that they are not guided by set fees or commissions. They can charge different amounts for varying services, so discuss these costs upfront.
Know the Possible Risks
Because leverage is one of the biggest risks involved with futures trading, it is crucial that you understand these risks and don’t put yourself in a position to sustain a significant loss. You can leverage up to 90% or 95% in the futures market, with only a little money out. Always know your potential loss, and make sure you can take the hit if it happens.
Determine Your Method
There are two primary ways you can get started investing in futures. The first option is to try your hand at it yourself with a broker, or you can choose a managed account. Managed accounts are run by professional investment companies that have commodity trading advisors specializing in futures.
Develop Your Plan
One of the biggest mistakes novices make is not creating a plan before starting. In your plan, define your risk tolerance, your goals, and your strategy for achieving those goals. Create a detailed plan that takes you step-by-step through each trade so you can easily monitor and articulate your exit strategy.
Choose Your Contracts
One of the difficult decisions to make when considering trading futures is which contract you want to consider. Making the decision will require studying the margin requirement, understanding the spread, assessing the contract’s liquidity, and researching the consistency of the daily volume.
Tips for Successful Futures Trading
When trading in the futures market, pay close attention to both volume and volatility. These are two of the most important things to keep track of, as they can help prevent a large loss. Below are a few other tips to help you navigate the world of futures contracts with greater success.
Always Use Caution When Selling Short
Short-selling is a risky type of investing, and it becomes even more so when you are trading futures. If short, you are betting on a loss that can potentially carry greater risk. Going long, your biggest risk is losing 100% of the money you invested. But when you sell short, there is no limit to the amount you might lose.
Create Your Mental Stops
Everyone has to have stops in their plan so they can control their trade, put their emotions aside, and avoid becoming overexposed to risk. These are often referred to as mental stops and are points you set for when you want to sell. Don’t simply rely on computer programs; also watch the market closely, and implement your mental stops to help minimize your risk.
Avoid Trading Large Positions
When starting out in futures trading, limit your starting trades to smaller ones. A good rule of thumb is to not invest more than 20% of your trading account on one play, as it can open you up to increased risk. By starting out trading smaller positions, you will be able to get the hang of the difference between futures and traditional stocks without risking a significant amount. Trading smaller also allows you to make more plays, which will help you learn the process more rapidly.
Focus on the Stock Futures Volume
Volume is an indicator that lets you know how often a stock’s price will fluctuate. Sometimes the best course of action is to invest a small amount of money on a higher-value stock. When a stock is in high demand, it means it’s a popular pick that’s attracting many players. High volume often translates to high liquidity.
The reason volume can be so important in the futures market is because even if it moves the opposite direction, bounce back can still occur in the future. Check your research to find reasons for recent changes in volume. Is the higher volume due to recent news about the company? Will the catalyst result in high volume for the long-term or short-term?
Many investors are attracted to trading stock futures because of the ability to hedge without increased risks. You can execute a contract at any time, allowing you to pull out when needed to mitigate risk. The crucial thing to understand is the difference between hedging and panicking. By making uncalculated decisions to pull out based on an emotional reaction to a drop, you are likely to see unrealized profits slip through your fingers. When you learn how to hedge against your options properly, you can better protect your wealth.
Trading in futures can be an effective way to add wealth to your portfolio and help prepare you for your financial future. If you want to learn more about how to trade in the futures market, sign up for our next webinar or download our free investing e-book today.