What You Should Know About Futures Trading

If you want to earn the highest returns possible on your investments, you may want to consider futures trading. However, this specific trading vehicle, which entails a contract to purchase or sell an asset at a fixed future amount and date, can seem murky and difficult to grasp.

Nevertheless, if you do your homework, you can use futures trades to safeguard your investments and maybe even see some small returns. This investment method doesn’t have to be hard.

To make it easier for you to get started, US News My Money explains what you should know about futures trading.

What Are Futures Contracts?

“A futures contract is a type of derivative security that determines its value from the performance of another security or property,” Robert R. Johnson, a finance professor at the Heider College of Business at Creighton University, told US News My Money.

In other words, it’s an agreement “in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed upon by the two parties when the contract is initiated,” Johnson explains.

This could advantage commodities producers who want to secure prices. Peter Davies, the CEO of Jigsaw Trading, offered an example of a farmer selling corn to Kellogg Co. so it can produce its Corn Flakes cereal.

In the example, Davies said that the farmer would sell corn futures, which assures that he can sell his crops at a specific price in the future. “That means he knows what he’ll earn for a crop,” Davies notes. “On the other side, Kellogg’s might buy corn futures to lock in the price of corn they will buy in the future, so they know what the Corn Flakes will cost to make.”

But futures encompass more than agricultural products. You can trade futures for other commodities like coffee, gold, natural gas, and more.

When a corporation uses futures contracts to lock in the price of a commodity for manufacturing. For example, if an airline uses futures contracts to hedge the cost of fuel, then the company will receive the item as a physical delivery. 

The average investor who engages in futures trading for oil won’t receive a barrel of crude on their doorstep. These trades can also be cash-settled, which means no delivery occurs. Instead, the person selling the commodity gets payment in the form of cash.

Are Futures And Options Trading The Same?

“Options contracts provide the holder with the right, but not the obligation, to do something,” Johnson explains. “The holder of a call option contract has the right to buy a specific asset at a specific price for a given time period. But the holder of a call option is not obligated to buy that asset. Both the buyer and seller of a futures contract are obligated to transact.”

According to Johnson, another notable difference between these two types of trading is that futures contracts call for a daily reconciliation of returns and losses. In other words, investors must balance their accounts at the close of each trading day.

This task might seem like a hassle initially, but based on the market’s direction, you could see more daily returns until your futures contract ends. Options trading, on the other hand, does not require this effort.

Who Usually Performs Futures Trading?

Robert Fitzsimmons, Wedbush Securities’ executive vice president of fixed income, commodities, and stock lending says that there are usually four types of futures investors.

The first category is commercial traders who have opposite risk positions. This would include “a farmer concerned about falling corn prices can go short futures while an ethanol distiller concerned about rising prices can go long futures,” Fitzsimmons says. 

The second group consists of futures traders indirectly engaged in the futures contract’s underlying assets’ manufacture and expenditure. Instead, Fitzsimmons explains these individuals are focused on making a profit from market movements. This category accounts for the large majority of futures traders.

Similarly, the last two types are also focused more on making a return rather than production. Professional investors — also referred to as commodity trading advisors or CTAs — who handle futures portfolios fall under this category.

Fitzsimmons notes that CTAs’ long position in a certain commodities future could be one component in an elaborate strategy, rather than their opinions on market movements. He also explained that there are also ETFs based on commodities. These utilize a series of long or short futures to stabilize a securities product intended to secure those goods’ movement.

Where Can You Trade Futures?

The majority of online brokerages allow you to buy and sell futures contracts. Before choosing a service, it would help if you got acquainted with individual brokers’ terms and conditions. 

Due to the risk of trading on margin, many online brokerages require that their clients have some experience before allowing them to trade futures. These platforms will also make sure that you have some margin available, which typically means you have to have so much money in your account. Some brokers may even mandate a test or course before trading with futures.

 

Source
  • Reeth, Mark. “Everything You Need to Know About Trading Futures.” U.S. News & World Report, U.S. News & World Report, 23 Dec. 2020, money.usnews.com/investing/investing-101/articles/futures-trading-basics-everything-you-need-to-know-about-futures.
Ian Schindler