For many investors, the futures markets, with all of the different terms and trading strategies, can be both confusing and daunting. There are opportunities to limit losses on your portfolio or enjoy significant profits by using the futures markets, but it is important that you understand how these derivative products work and how you can achieve those profits consistently. This article explains how each market works and the different strategies that you can use to make money.

Key Takeaways

  • Futures markets allow people to buy and sell claims to some underlying asset for future delivery.
  • Speculators can use leverage to bet on the price of various underlying securities, from stock indices to commodities to currency exchange rates.
  • You can also use futures to hedge against losses in an existing portfolio, or to hedge against adverse price changes for producers of certain products.

How Can You Be Successful?

The futures markets are where hedgers and speculators meet to predict whether the price of a commodity, currency or particular market index will rise or fall in the future.

Like any market, this one has risks when trading, but the potential to see both short- and long-term gains can be substantial, thanks in part to the huge amounts of volatility that these markets are known for having. Here are a few of the different futures markets, along with different strategies that you can use to make money in them.

Commodities

A commodity is a physical product whose value is determined primarily by the forces of supply and demand. This includes grains (corn, wheat, etc.), energy (such as natural gas or crude oil) and precious metals like god or silver, just to name a few.

A commodity futures contract is an agreement to buy or sell a predetermined amount of some commodity at a specific price on a specific date in the future. Like all futures contracts, commodity futures can be used to hedge or protect an investment position or to bet on the directional move of the underlying asset.

For individuals, you can access commodities futures markets primarily through a managed futures account, available through specialized brokerage firms called Commodity Trading Advisors (CTAs).

Many investors confuse futures contracts with options contracts. With futures contracts, the holder has an obligation to act. Unless the holder unwinds the futures contract before expiration, they must either buy or sell the underlying asset at the stated price.

Currencies

Currencies, or forex, trading involves looking to make money or hedge risk among the movement of foreign exchange rates. One commonly used strategy to trade currencies is scalping. Scalpers attempt to take short-term profits off incremental changes in the value of a currency. Doing this over and over again means that your profits will continue to add up over time, giving you significant total profits when you add all the small profits together.

In general, your timeframe can be as short as one minute or may last several days. A scalping strategy requires strict discipline in order to continue making small, short-term profits while avoiding large losses.

A wide variety of currency futures contracts are available. Aside from the popular contracts such as the EUR/USD (euro/U.S. dollar currency futures contract), there are also E-Micro Forex Futures contracts that trade at 1/10th the size of regular currency futures contracts, as well as emerging market currency pairs such as the PLN/USD (Polish zloty/U.S. dollar futures contract) and the RUB/USD (Russian Ruble/U.S. dollar futures contract).

Different contracts trade with varying degrees of liquidity; for instance, the daily volume for the EUR/USD contract might be 400,000 contracts versus only 400 contracts for an emerging market like the BRL/USD (Brazilian real/U.S. dollar).

Currency futures are exchange-traded futures. Traders typically have accounts with brokers that direct orders to the various exchanges to buy and sell currency futures contracts. A margin account is generally used in the trading of currency futures; otherwise, a great deal of cash would be required to place a trade. With a margin account, traders borrow money from the broker in order to place trades, usually a multiplier of the actual cash value of the account.

Currency futures should not be confused for spot forex trading, which is more popular among individual traders.

Indexes

Another category of futures popular with investors are index futures, such as the S&P 500 index futures contract. However, each futures product may use a different multiple for determining the price of the futures contract. As an example, the value of the S&P 500 futures contract is $250 times the S&P 500 index value. The E-mini S&P 500 futures contract has a value of 50 times the value of the index.

Index futures are also available for the Dow Jones Industrial Average (DJIA) and the Nasdaq 100 along with E-mini Dow (YM) and E-mini NASDAQ 100 (NQ) contracts. Index futures are available for foreign markets including the German, Frankfurt Exchange traded (DAX)—which is similar to the Dow Jones—the SMI index in Europe, and the Hang Seng Index (HSI) in Hong Kong.

Index futures are a way to get into a passive indexed strategy, by owning the entire index in a single contract, and with greater leverage than an ETF would provide. Both the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority, Inc. (FINRA) require a minimum of 25% of the total trade value as the minimum account balance. However, some brokerages will demand greater than this 25% margin.They are also used to hedge against large stock positions.

Interest Rates

Futures contracts on interest rates are also very popular contracts. Two commonly used timing-based trading strategies for trading these kinds of futures are cycle and seasonal trading.

A cycle trading strategy is implemented by studying historical data and finding possible up and down cycles for an underlying asset. Two commonly used cycles for stock index futures are the 23-week cycle and the 14-day cycle. Studying the price trends associated with cycles can lead to large gains for savvy investors.

Seasonal trading, on the other hand, is when you attempt to trade the seasonal effects that take place in the futures markets. Historical data suggests that many markets, sectors and commodities trade at varying levels throughout the year and show similar patterns year after year. Knowing these different seasonal trends is another effective way to make money trading futures.

Try It Out

Getting started in the different futures markets can seem daunting. One way that you can learn as you go without putting any of your money at risk is to start out paper trading. Paper trading is done by mimicking trades by yourself (or with a market simulator) until you feel that you are comfortable enough to begin actually trading.

A good way to start is by concentrating on these four different areas. This will help build your knowledge as you go along without increasing your overall amount of risk. Then, as you feel that you have mastered these areas, try expanding into trading other types of futures.

The Bottom Line

Trading the different futures markets can be very rewarding but also very challenging. For young investors, there are many different markets and strategies that you can use to be successful, including the ones we discussed here. By doing your research and making sure you understand how futures work, you will have the opportunity to enjoy a great deal of success trading in the futures market.