All you need to know about trading futures

Author: Martin Moni
Martin Moni
All publications of the author

Futures, or futures contracts, are a form of financial instrument that involves a contract between 2 parties to buy or sell an asset at a certain time in the future. The term futures contract more accurately describes this financial instrument because it involves merely a contract between two parties, without an immediate exchange of money. Instead, the exchange of money is done at the specified time in the future, when the asset is delivered.

What is traded in the futures market?

There are 4 categories of assets that can be traded in the futures market:

  • Agricultural futures – these are basically farm produce or stuff that can be grown or raised including agricultural goods such as grains (wheat, soy beans, etc.), livestock and tropical goods (sugar, coffee, etc.)
  • Industrial futures – this category includes products that are essential to manufacturers of products. They include energy products (crude oil, WTI, natural gas, etc.), metals (gold, silver, copper, etc.) and building materials
  • Financial futures – there are also certain assets that are not tangible, but they can be used by speculators as a form of betting against each other. They can be foreign currencies (similar to the Forex market, except that the trade is made at a later date), interest rates and stock indices (FTSE 100, S&P 500, Nikkei 225, etc.)
  • Stocks – individual stocks, too, can be traded in the futures market, e.g. Apple, Microsoft, Pfizer, etc.

 

History of futures contracts

About 150 years ago, the agricultural revolution took the world by storm, and farmers were able to produce more crop than ever before. Fritz Haber, a German chemist, had discovered how to make ammonium nitrate which would help crops grow faster and healthier. Nevertheless, agricultural technology was still not as advanced as it is today, and crops were still vulnerable to the ravages of weather and pests. This made the trade of agricultural products unpredictable from one year to the next, and there was a lot of uncertainty among farmers.

Until some economists came up with a great idea. Imagine a farmer who just planted their wheat, but they would only harvest and earn from their crop after, say, 8 months. The year before was not good for the farmer, a pest had invaded his crop and the harvest was small, so he did not make as much of a profit as he had hoped. Therefore, he needs some urgent money, and despite weather forecasts predicting a good harvest in the current year, he can’t wait 8 months.

So, he approaches someone with plenty of money and offers to turn over all of his harvest for the year in 8 months, provided he got the money immediately. The rich man knows that this will be a good year for farmers, and so he agrees to give the farmer the payment upfront, but at a reduced price, since he is the one taking all the risk. The farmer, being in desperate need for money agrees to the deal and takes the money. After the crop is grown, he hands over all the crop to the man who paid for it and the debt is settled. Whether the harvest is abundant or paltry, that doesn’t matter because the contract is filled.

This is how the futures market began and, in principle, this is how it still works today, although technology has made the process a lot smoother.

This system became very popular among farmers who enjoyed the financial security and the buyers who would make huge profits if their predictions were correct. Soon, it was being done in major exchanges around the world including Japan, India, England and the US; although it was all for agricultural products such as wheat, coffee, sugar, etc.

As people became more used to the concept of futures, the futures market expanded away from its agricultural roots, and this expansion culminated around 1972 when the International Monetary Market (IMM) was created as a branch of the Chicago Mercantile Exchange (CME). The creation of the IMM added the trading of currency futures, along agricultural product futures, where traders would speculate on the value of foreign currencies at a later date. By 1976, the IMM also included interest rate futures and stock market index futures were introduced in 1982. Later on stock futures were also offered.

All this time, futures were traded physically at the various exchanges around the world, but the internet has changed this now. You don’t have to be physically present at the trading floor anymore because futures can be bought or sold online. In addition, the ability to trade in the futures market opened the trading of futures to individual traders who had no need for the actual physical commodities, which is what most traders do.

How the futures market works

The futures market is created initially by individuals or companies that would like to ensure financial security for their products. Let’s take the example above of a wheat farmer who would like to secure the year’s income by selling wheat futures. Initially, the futures market was not as regulated as it is today, but the popularity of this system had led to more specificity. There terms of the futures contract must be very specific, and these include:

  • Quantity – the quantity of product to be delivered must be specified. A standard contract for wheat, for example, is 5,000 bushels, while the standard for crude oil is 1,000 barrels
  • Quality, type and grade – the worry in futures lies with the individual who promises to buy a commodity in the future, since there is no guarantee the seller will maintain quality. In the case of the wheat farmer who has already sold his wheat, he would not have any motivation to keep the quality of his crop high. Therefore, the futures contract must also specify the quality of product to be delivered
  • The price per unit – this is usually the price of the commodity in the market at the time of the contract signing
  • Date and method of delivery – when the contract expires must be specified, too, and how the product will be delivered

All these conditions must be met for the futures contract to be completed, and if any of the parties is not satisfied, the contract can be cancelled. However, if the buyer of the futures contract is not satisfied and does not agree to cancel the contract, then the seller must find the commodity from the market to replace his own produce to avoid a lawsuit.

Continuing with the example of the wheat farmer, say, he agreed to deliver 5,000 bushels of wheat in 8 months at the current market price of $5. In this case, the farmer has sold the commodity, and therefore holds the short position while the buyer of the commodity holds the long position. The only difference between a futures contract and a regular trade is that the delivery of the product is in a later date and not on the spot.

Just like the Forex market, though, the price of a commodity will shift over the period of the futures contract as the futures market sentiment responds to news announcements. Let’s say that, after a month, the weather forecast predicts that there will be plenty of rain throughout the year. This would mean that there will be plenty of wheat produced in the year, and the price of wheat drops because there will be a lot of wheat in the market.

In effect, the price of wheat drops in the market from $5 to $4. Unlike the Forex market where changes in price of an asset are reflected immediately on the accounts of the participants, the futures market credits and debits the accounts of the 2 parties on a daily basis. In this case, the wheat farmer would have gained $1 for every bushel of wheat, and his account credited with $5,000 at the end of the trading day, while the buyer’s account would be debited with $5,000. These adjustments are made daily, and each party can see how their account is performing.

Normally, if the parties involved in the contract were actual buyers and sellers, they would wait for the entire period of the contract. However, this situation opened the door to speculators who had no need for the actual commodity, and instead they would settle the contract with cash rather than the actual commodity. If the farmer and buyer in the above example were just speculators, then they would not have any use for 5,000 bushels of wheat, and after a month, the ‘farmer’ could choose to close his position with a profit of $5,000.

How to trade futures

Now that you know how the futures market works, you might be interested in participating there and making some money. You can look through the Forex broker list to find out if a particular broker also offers futures contracts, but there are still a few things you require:

Initial deposit

Because a futures contract is an agreement for payment and delivery at a later date, there is no exchange of money between the buyer and seller at the time of the contract signing. However, the futures exchange requires an initial deposit, also called the initial margin, before the contract is approved. This is usually about 5% to 10% of the value of the contract, and is kept by the futures exchange, where any profits or losses are added or deducted daily.

Leverage

Another advantage to trading futures is that they can have a very high leverage since only the initial margin is required. Your broker might offer you very attractive leverage percentages which would allow you to trade huge amounts of futures and potentially make huge profits. However, you should be careful with these exorbitant leverages because if you start losing, the initial margin can be wiped out very quickly.

Who trades futures?

Futures trading is very similar to trading contracts for difference (CFDs) because they both rely on the value of an underlying asset. In fact, if you compare CFD brokers and futures brokers, there won’t be any major difference and most CFD brokers will also offer futures contracts. There are various parties involved in the trading of futures, such as:

Manufacturers/producers

Companies that manufacture goods from certain commodities prefer to buy futures of that commodity instead of waiting for the commodity to become available. These parties are known as hedgers.

For example, Intel is the world’s biggest manufacturer of computer processors, and among the materials needed to make a processor is gold. They could wait for gold to be mined from South Africa and buy it from the market at the market price, but the value of gold is always fluctuating.

Consider the gold boom after the BREXIT vote on the 23rd of June (find out more about the effects of BREXIT here), whereby the value of gold rose drastically by almost 20% as investors bought more stock in gold. Gold is usually the safest asset to own during a financial crisis since it will always be valuable. For a company like Intel which depends on gold, such a spike would put a dent in their profits, and yet they would have to do it since it is an essential raw material.

Unless they had futures – if Intel had bought gold futures months before the BREXIT vote, say, in January 2016 when the referendum date was set, then they would not suffer from the rise in value of gold.

Once the terms of a futures contract are agreed upon, they cannot be changed, and this is why big manufacturers love the futures market – it eliminates price risk and allows the manufacturer to plan more effectively for the future.

Speculators

These are normal people like you and I who study trends in the futures market on our Forex trading platforms but don’t want to actually purchase the asset. After all, what would you do with a barrel of crude oil that got shipped to your home. The futures market creates a different opportunity for a trader which has its own benefits and downsides.

One of the main advantages to trading futures is greater scrutiny. All futures are traded through an exchange such as the Chicago Mercantile Exchange or the London Stock Exchange. This is unlike the Forex market which is handled by a dealing desk whereby the trader essentially trades against the broker. With futures, the trader might still have to deal with a broker, but the broker only earns from the spread or commission but he cannot intervene in the trade, thereby allowing for more transparency.

However, it still has its downsides, such as a marked reduction in liquidity. Compared to the Forex market which experiences about $5.1 trillion of trade volume in a day, the futures market has about $100 billion traded on an average day. Besides, futures trading requires a much bigger capital compared to the Forex market, even with leverage offered by the broker.

Major investors

Big players in the financial world prefer to make long-term trades instead of day trading, and futures contracts provide this kind of environment. Futures contracts can be set to expire several months or years after the contract is entered, which allows the trade to ‘mature’.

Furthermore, they are also very secure compared to stocks. On the 6th of May 2010, there was a stock market crash known as the 2010 Flash Crash that lasted for almost 36 minutes whereby the value of stock indexes dropped drastically. During the crash, ETFs fell to lows of about a penny a share. During this time, many trades were cancelled and broken, which led to investors losing their money. However, futures contracts remained secure despite the crash, dipping only slightly before bouncing back.

A similar situation happened this year on the 30th of May 2016 when China’s CSI 300 futures index crashed by over 12.5% within seconds, but quickly recovered. This is an example of how stable the futures market really is.

For a major investor who has hundreds of millions and perhaps billions invested, security of their investment is a crucial factor to be considered, and futures contracts provide exactly that.

Choosing the right futures broker

Unlike the Forex market which is decentralized, the futures market has to be done through a futures exchange. This means that every futures broker has to be connected to the futures exchange that offers the asset you would like to buy or sell. Since the whole system is centralized, all trades are public and can be seen by everyone. This is not the same for the Forex market where the broker can act as the market maker and your trades are not recorded anywhere else.

This centralized system also presents a slight caveat – no single futures exchange can provide all types of futures. There are currently over 90 futures exchanges in the world, and each of them deals with the assets available in the region they are situated. The London Metal Exchange, for example, deals with industrial futures, particularly metals such as aluminium, copper and steel.

Considering that a futures broker has to be connected directly to the futures exchange as a member, it is not possible for a futures broker to offer all the futures available in the world. Therefore, a London-based futures broker may be connected to the London Metal Exchange, but not the Intercontinental Exchange in New York where you could find agricultural futures. This means that you have to know the kind of futures you want to trade before signing up with the broker, then making sure they can offer that particular futures contract. Visit this page for a list of futures trading brokers we know.

Simply put, you won’t get the luxury of having access to all the futures available worldwide, unless you are willing to travel physically to the futures exchange’s headquarters.

Here's a refresher on all you've read about futures with real-life examples:


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