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What is Futures Trading?

Futures trading is the buying and selling of futures contracts. Futures contracts are standardized legal agreements where a buyer and seller agree to exchange commodity at a specific price at a particular future date.

While this may sound simple enough, futures trading can quickly become incredibly complex. In this post, we’ll break down all the various aspects of futures trading, including what futures are, how they’re used, how they differ from other financial products, and their advantages and disadvantages.

What are Futures?

Futures trading involves buying or selling futures contracts (generally referred to as futures). A futures contract is an agreement to buy or sell an underlying asset at a specific price in the future. The buyer of the contract is required to purchase the underlying asset upon the expiration of the futures contract. The seller is required to provide the underlying asset to the buyer upon the contract’s expiration.

There are two main uses of futures. The first is hedging. This is typically done by the companies that produce the underlying asset. The other use for futures is speculation, which is more often how traders use futures. Even if you only plan to use futures for speculative purposes, understanding how companies use futures contracts for hedging can help you better understand the futures industry. So, we’ll begin with a look at hedging and speculation in futures trading.

Hedging

Hedging is a strategy to help minimize risk. You could loosely compare it to the purchase of insurance. There are many ways and types of hedging, but when it comes to futures, hedging helps protect against price changes in the underlying asset.

Typically, companies that produce the underlying assets use futures to protect themselves from future price fluctuations. To see how companies can use futures as a tool for hedging, we’ll look at an example using crude oil, a popular futures commodity.

An oil producer plans to produce a set number of barrels of oil, but the barrels of oil will not be ready to sell until one year from now. The problem for the oil producer is that oil prices fluctuate. The current price for a barrel of oil may be $50, but there is no guarantee that it will be $50 one year from now when the oil producer is ready to sell the oil. This creates a risk for the oil producer. If the price of oil drops between now and when the oil producer is prepared to sell the oil, the company could end up with much less money. This is where futures contracts come in.

The oil producer could choose to enter into a futures contract to hedge against a price drop in oil. When the oil producer enters this contract, it will receive a set rate for the oil produced when it sells it a year from now, regardless of the price of oil. For example, if the price of oil is expected to increase, the oil producer may enter into a futures contract of $52 per barrel for 10,000 barrels, set to expire in one year. When the contract expires, the oil producer will receive $520,000 and will provide 10,000 barrels of oil, regardless of the price per barrel. This protects the oil producer from losing money if the price of oil drops.

Speculation

We’ve seen how companies can use futures for hedging, but where do investors come in?

Traders typically use futures to speculate on the rise or fall of a commodity’s price. Traders can do this by purchasing a futures contract whose underlying entity they believe will have a different price than the price listed in the futures contract.

Even though the value of the contract is based on the expiration date, much like stocks, the value of futures fluctuates based on the market for that commodity. This means that trading futures does not require you to wait until the futures contract expires to make or lose money.

If a trader thinks the price of a commodity will go up, that trader can purchase that commodity’s futures. If the price does go up, the trader will make a profit. Of course, if the commodity’s price decreases, then the trader will have lost money. This is not the only way to trade futures, though. If an investor thinks the price of a commodity will drop, the trader can short the future. In this case, the opposite of the above occurs. If the commodity decreases in price, the trader makes money, and if the commodity increases in price, the trader loses money.

While commodity futures, such as our crude oil example above, are a popular type of futures trading, the futures market also extends beyond commodities. Traders can also purchase stock index futures, currency futures, precious metal futures, and U.S. Treasury futures.

Future Trading Terms

Since futures trading involves some unique terminology, if you’re interested in futures trading, you’ll need to learn some of the key terms.

Tick

A tick is the increment used to measure the movement in the price of a futures contract. Different products have different ticks.

Tick Size

Tick size varies depending on the product and relates to tick value.

Tick Value

Tick value is expressed as a dollar value. With stocks, the value of each tick is one penny. This is not the case for futures. Since tick size is different depending on the product, the tick value, therefore, varies from product to product, as well.

Contract Size

The contract size is the amount of the underlying asset backed by that contract. The contract size is set per product. That means each contract with the same underlying asset has the same contract size.

We’ll now return to our earlier example of crude oil, and see how these terms apply.

The contract size of oil is 1,000 barrels. All futures contracts for oil will, therefore, come in denominations of 1,000. For example, you may enter into a futures contract for 5,000 barrels of oil or 27,000 barrels of oil, but you can’t enter into a futures contract for 1,270 barrels of oil. Oil has a tick size of one cent per barrel, which comes out to $10 per contract. The price of oil futures per contract, will therefore increase or decrease by $10 increments.

Advantages and Disadvantages of Futures for Companies

Now that we understand some of the key terminologies, we’ll turn our attention a few of the advantages and disadvantages of futures. We’ll start with the advantages and disadvantages of futures for companies that use it as a tool for hedging. Again, even if you’re only interested in the speculative aspect of futures, understanding all aspects of the futures market can help you make more informed trading decisions.

Futures contracts can help companies in several ways, including providing more stability. The company knows it has a buyer, and it knows the exact amount it will receive. In industries with high levels of price volatility, this is huge. As discussed above, companies can also use futures to protect themselves from an adverse price movement (hedging).

Futures also come with some potential risks for companies. A futures contract can help a company avoid losing money if the commodity price decreases before the end of the contract period, but it also limits the upside potential. If the price of the commodity increases, the company can miss out on an opportunity to make money. Again, there’s no free lunch.

Let’s return to our crude oil example to see how these advantages and disadvantages can play out for a company.

In our example, the oil producer entered into a futures contract of $52 per barrel for 10,000 barrels, set to expire in one year. Let’s say one year after entering into the contract, the price per barrel is $50. If this were the case, the company would have avoided the decrease in price. Thanks to the futures contract, the company would sell 10,000 barrels for $520,000. If the company had not entered into the contract, it would have had to sell those barrels for the market price of $50 per barrel, meaning the company would have sold those barrels for $500,000 - a $20,000 price difference.

But the opposite could also occur. Let’s say the price of oil increases to $54 per barrel. At the market price, the company could sell the 10,000 barrels and make $540,000, but since the company entered into a futures contract, it must sell the barrels for the agreed-upon $52 per barrel. Meaning the company would sell the 10,000 barrels for $520,000 instead of $540,000, which causes the company to lose out on $20,000.

Futures contracts come with both potential advantages and disadvantages for companies. The same also applies to traders.

Advantages and Disadvantages of Futures for Traders

One of the most significant advantages of futures trading is that it comes with some unique opportunities and the potential for dramatic returns on your investment. The high potential for profits is based mainly on the use of high leverage.

What does it mean to use high leverage?

When trading futures, instead of having to put down the entire value of the contract, the trader can instead put down an initial margin amount, which is only a small amount of the value of the contract. The exact amount of the initial margin will depend on the terms and conditions of the broker, the size of the contract, and the investor’s creditworthiness. One of the most significant advantages of trading in this way, unlike stock investment, is that you can potentially magnify your profits with lots of leverage.

The use of high leverage is a potential advantage of futures trading, but it can also be considered one of its main disadvantages. High leverage comes with more risk. Adding to futures trading’s level of risk is its high level of complexity. Anyone interested in futures trading must understand the risks associated with futures trading, which brings us to our next point.

Risk and Futures Trading

All investments include some level of risk. Futures trading involves many of the same types of risks as other investments, such as the risk of interest rates increasing, causing the price of the security to reduce or varying levels of liquidity. Still, the one area where futures trading involves far more risk than many other investments is leverage.

One of the most important things to consider before trading futures is how leverage impacts the futures market. Let’s look at the math behind leverage and how it impacts both returns and losses.

The difference between a typical investment, such as the purchase of a stock and futures trading is based on the difference in the amount of money invested. The initial margin amount, which is how much traders must put down to purchase a futures contract, typically ranges from about five to ten percent of the total value of the contract.

While the initial margin amount for crude oil is a set amount depending on the specifics of the contract, we’ll continue to use our crude oil example for the sake of clarity and consistency. We will assume the initial margin rate is 10%. The crude oil contract we’ve discussed of 10,000 barrels of oil at $52 per barrel, is worth $520,000. But to purchase this entire contract, with an initial margin rate of 10%, a trader would need only $52,000.

In this case, if the value of oil dropped by 10%, your investment would see a drop in value of 10% or $52,000. This means you would have seen a drop in value equal to 100% of the initial margin deposit. The reverse is also true. If oil prices increased by 10%, you would see a 10% gain, or $52,000. You would have then seen a 100% gain relative to the initial investment.

Futures trading offers the same potential for profit that owning the underlying investment outright does. The difference is that the high leverage used in futures trading can lead to much more dramatic gains and losses compared to the amount of money invested. Consequently, futures trading with lots of leverage is not ideal for those who have a low risk tolerance.

Options vs. Futures

Before we wrap up, we should touch on a critical point that often arises when discussing futures - the difference between options and futures. Those familiar with options trading will see that the two kinds of trading have many similarities. Both allow speculators to attempt to exploit potential future price differences by entering into contracts regarding the future price of an asset. Both futures and options can also be used for hedging. But the way these two financial products work, and the level of risk associated with each of them varies drastically.

The essential way options differ from futures is right there in the name. When you purchase an option, you have the ability (or option) to buy or sell the asset listed in the contract if the asset reaches the price listed in the contract during the time the contract is in effect. But if you don’t want to buy or sell the asset, you have no obligation to do so. In contrast, at the expiration of a futures contract, an asset is being bought/sold. There is no choice involved.

There’s also the risk level to consider. As previously mentioned, futures generally come with a high level of risk in relation to the sum invested. While options come with a reasonably high level of risk, due in large part to their complexity, as a general rule, futures come with much more risk.

How to Get Started Trading Futures

If you have an interest in starting to trade futures, getting started is relatively similar to any other type of trading. All you’ll need to do is find a broker that allows for trading in futures and open an account with that broker. As with any other type of account, you should expect to answer some questions about your financial situation, goals, and experience level. When working with a futures broker, there may be some additional questions, since your broker will need to understand the level of risk you can handle.

Managed Futures & Risk-Adjusted Returns

For those who aren’t interested in speculatively trading futures, managed futures funds can be added to a diversified portfolio to increase risk-adjusted returns.

The Takeaway

Futures are a complex financial product, and they come with a high level of risk. Therefore, futures trading is certainly not for everyone. But even if you never trade futures, understanding how they work increases your investing acumen, which can never hurt. Additionally, adding managed futures may be a way to enhance risk-adjusted returns.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.