Futures aren't a new type of financial instrument. In fact, they came about in the mid-19th century, allowing grain farmers to sell their wheat for forward delivery. Since then, they've evolved to include different securities and financial instruments, along with other commodities.
Futures trading provides investors with a fast and cost-effective means of accessing global financial and commodity markets. Investors can speculate or hedge on the price direction of the particular security or instrument they're trading. This is done by purchasing a futures contract. A futures contract is a legal agreement to buy or sell an asset at a predetermined price at a specified time in the future.
But what are the pros and cons of trading futures? This article explores some of the benefits and challenges you may encounter while trading your futures.
- Investors can trade futures to speculate or hedge on the price direction of a security, commodity, or financial instrument.
- Key futures markets include stock indexes, energy, currencies, cryptocurrencies, interest rates, grains, forestry, and livestock.
- Advantages of futures trading include access to leverage and hedging while disadvantages include overleveraging and challenges presented by expiry dates.
- Choose a futures trading platform that is intuitive, offers multiple order types, and has competitive fees and commissions.
- A basic futures trading plan should include entry and exit strategies as well as risk management rules.
The Basics of Futures Trading
As its name suggests, a futures contract is a financial instrument through which a buyer and seller agree to transact an asset at a fixed price at a future date. Despite a futures contract providing the opportunity for the delivery of an asset, most don't result in physical delivery but are rather used by investors to speculate on a security's price or hedge risk in a portfolio.
Traders can speculate on a wide range of securities and commodities by trading futures. Key futures markets include stock indexes, energy, currencies, cryptocurrencies, interest rates, grains, forests, and livestock.
Most futures contracts are traded through centralized exchanges like the Chicago Board of Trade and the Chicago Mercantile Exchange (CME). Many cryptocurrency brokers, such as Binance, offer perpetual futures—a contract without an expiry date—allowing traders not to worry about an expiry month.
Futures trading requires investors to settle their contracts. This is in contrast to options trading, which gives the trader the right but not the obligation to settle their contracts.
Advantages and Disadvantages of Futures Trading
Just like any other strategy or trading method, there are some key benefits and drawbacks that you should be aware of before you start. These points are just as valuable if you're a novice investor or if you're a seasoned pro.
- Leverage: Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Futures are traded with leverage on margin, allowing investors to control larger positions with a small initial outlay. However, this can be a double-edged sword if the asset's price moves in the unintended direction. Traders should be aware they can lose more than their initial margin when trading futures contracts.
- Diversification: Investors can trade futures on everything from stock indexes to orange juice, helping to provide a diversified portfolio across multiple asset classes.
- After-Hours Trading: Futures allow traders to take advantage of opportunities nearly around the clock. For example, a trader may wish to go to long futures contracts on the Nasdaq 100 Index if several mega-cap technology stocks report better than expected earnings after the market close.
- Hedging: Investors can use futures to protect unrealized profits or minimize potential losses. The wide selection of futures products available allows traders to take a cost-effective hedge against the broader market or specific sectors and individual commodities.
- Complex: While anyone can trade futures, there are some complexities involved that can make this a complicated process. You will require a good deal of time and effort if you want this strategy to be successful. This means monitoring the market and keeping on top of current events.
- Over-Leverage: Leverage is a double-edged sword. On the one hand, it can be advantageous to amplify returns with less of a cash outlay. However, if markets turn against you, you will be responsible for the full amounts of the losses and be subject to margin calls. In other words, leverage will also amplify losses.
- Managing Expiry Dates: Most futures contracts have an expiry date that traders need to monitor. As the contract approaches its expiry, its price may rapidly lose value or even become worthless. To combat this, investors frequently roll forward their futures contracts to a longer-dated one as the expiry date approaches.
- Physical Delivery: If you fail to close your positions or you don't trade them off into offsetting contracts over, you do run the risk of taking physical delivery of the underlying asset. At this time, you'll have to pay the agreed-upon price.
Wide array of asset classes
Easy to short the market
Extended trading hours
Must manage contract expiration
Failure to roll or close positions can lead to physical delivery
Selecting a Futures Trading Platform
Investors should do their research as they work through selecting a futures trading platform. But what criteria should you be looking for as you decide on one? Here are a few things you should make sure your platform can do for you:
- Is intuitive to use
- Offers multiple order types to help with risk management
- Has competitive fees and commissions
More advanced traders may want a platform that provides application programming interface (API) access to allow algorithmic trading functionality. Active traders should select a futures platform with a mobile trading app that lets them execute trades and manage positions on the go.
Most full-service online brokerages and trading platforms have access to futures trading. You will need to request and be granted approval to begin trading these markets.
Developing a Futures Trading Plan
As with trading stocks or other financial assets, it's important for investors to develop a plan for trading futures that outlines entry and exit strategies as well as risk management rules.
If a trader uses technical analysis to locate entries, they may decide to open a long futures trade on a golden cross signal—when the 50-day simple moving average (SMA) crosses above the 200-day simple moving average. The trading plan could also include a stop-loss order placed 5% below the entry price to manage downside risk.
On the other hand, a futures trading plan that's centered around fundamental analysis might generate buy or sell signals based on crop or energy inventory reports. For instance, a trader may short an oil futures contract if weekly oil inventories grow at a faster pace than analysts had expected. Of course, some traders may incorporate both technical and fundamental analysis into their futures trading plan.
In general, there are three futures trading plans:
- Long: Buy futures and profit when the prices increase.
- Short: Sell futures contracts and profit when the prices decrease.
- Spread: Simultaneously buy different futures contracts and profit when the relative price difference widens (or narrows). These can be on the same underlying but using different expiration dates, or on futures in two closely-related products like crude oil and gasoline.
Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.
Before trading futures, investors need to know several key elements about futures contracts to help determine position size and manage risk. These include contract size, contract value, and tick size. We’ll use the popular E-mini S&P 500 futures contract offered by the Chicago Mercantile Exchange (CME) as an example.
- Contract Size: As its name suggests, the contract size refers to the deliverable quality of the asset that underlies the futures contract. For example, the E-mini S&P 500 is $50 times the price of the S&P 500 index.
- Contract Value: Investors calculate the contract value by multiplying the contract size by the current price. Let's say a trader holds one contract of the E-mini S&P 500 and the underlying index trades at $4,800. This means the contract value equals $240,000 ($50 x $4,800).
- Tick Size: The tick size refers to the minimum price change of a futures contract. In other words, the smallest amount that the price of a particular contract can fluctuate. For instance, the E-mini S&P 500 has a tick size equal to one-quarter of an index point. As one index point equals $50 in the E-mini, one tick is the equivalent of $12.50 ($50/4).
Futures Markets to Trade
Futures contracts are listed on several different products comprising many different asset classes. Among the most popular include:
- Equity indexes, such as the S&P 500 or Nasdaq 100
- Hard commodities like precious metals
- Soft commodities, including agricultural products like livestock or crops
- Energy, such as crude oil and natural gas
- Currencies, including pairs like EUR/USD or GBP/JPY
- Treasury securities like U.S. government bonds and rates
- Crypto, including Bitcoin and Ether
Steps on How to Trade Futures
The following are some of the key steps that you should follow in order to start trading futures:
- Understand how it works. Trading futures contracts isn't necessarily the same as regular trading. That's because there are complexities that you'll need to comprehend, including how contracts work, the expectations as a buyer or seller, and expiry dates.
- Know the risks. There are certain risks inherent in futures trading that you won't find anywhere else. Among these are price sensitivity and margin trading, which means that you use leverage or borrowed capital to make your trades.
- Pick your market. Will you trade stock futures or commodities? Or do currency and interest rate futures pique your interest? If you're keen on international markets, you may want to consider bond and Treasury futures. But these aren't the be-all-and-end-all of futures trading. In fact, there's a wide range of choices from which you can choose.
- Narrow down your investment strategy. Will you go long or go short? Or will you decide to go long and short by using calendar spreads?
- Finally, choose your trading platform. Remember the tips we highlighted above on choosing the one that is best suited to you and your trading needs.
Putting It All Together
Now that we've explored the basics, let's put everything all together in a trading example using the E-mini S&P 500 futures. Say the S&P 500 index recently broke out to a new all-time high, and we want to fade the move, hoping to book profits on a retracement to the initial breakout area around $4,720. Our money management rules stipulate that we risk no more than 1% of our futures trading account on any one trade and our broker requires a margin of $12,000.
Knowing this information, we decide to open a short position, trading one contract and managing risk by placing a stop-loss $25 (or 100 ticks) above our entry price of $4,786. As we risk $1,250 ($12.50 per tick x 100), we should have at least $125,000 in our futures trading account to meet the 1% risk per trade rule ($1,250 = 1% of $125,000). Ideally, we should have more in our account to cover the $12,000 margin requirement and guard against margin calls if the price of the S&P 500 moves against us.
We then place a take-profit order at the initial breakout area at $4,720 (264 ticks) or $66 below our entry price. If the market moves in our favor and hits the order, we make a profit of $3,300 ($12.50 per tick x 264).
Conversely, we incur a $1,250 loss if we get stopped out. In any case, the future trade offers a favorable risk/reward ratio of 1:2.64 or $1,250 risk per contract versus $3,300 reward per contract.
What Assets Can Be Traded Using Futures?
Futures contracts are financial instruments that allow investors to speculate or hedge their bets on the price movement of a specific security or asset in the future. There is no limit to the type of assets that investors can trade using these contracts. As such, they can trade the following futures: stocks, bonds, commodities (energy, grains, forestry, livestock, and agricultural products), currencies, interest rates, precious metals, and cryptocurrencies, among others.
What Are the Key Advantages and Disadvantages of Trading Futures?
Investors should have a basic if not thorough understanding of how futures trading works before they begin. Knowing the benefits and drawbacks can spell the difference between success and loss.
Some of the main advantages include being able to use leverage (borrowed capital) to execute trades, the ability to choose from a diverse set of financial contracts, nearly round-the-clock trading, and being able to take a cost-effective hedge against the broader market.
On the other hand, investors should understand that futures trading can be fairly complex and it can lead to overleveraging. It may also be difficult to juggle and monitor expiry dates, especially if investors trade multiple contracts. Finally, traders run the risk of having to take physical delivery of the underlying asset if they don't close out or roll their positions into an offsetting contract by the expiry date.
What Should I Look Out for When Selecting a Futures Trading Platform?
Trading platforms for futures trading should align with your trading strategy and financial situation—the same way you would choose to a platform for any other financial transactions. Some key considerations you may want to take into account include how intuitive it is and whether it offers multiple order types. You should also review the platform's fees and commissions and ensure they are competitive.
What Are Some Basics to Include in a Futures Trading Plan?
A futures trading plan will revolve around your specific trading strategy. That is, your plan should factor in if you're a technical analyst or if you use fundamental analysis in your trading. You may choose to go long or short, or you may decide to use calendar spreads. Whatever you choose, it's always a good idea to plan your entry and exit strategies and basic risk management rules.
The Bottom Line
Futures are derivative contracts that let you speculate on the future price of some asset or commodity, or to let you hedge against existing positions. Because they utilize leverage, futures can amplify your bets, making for larger returns, but also larger losses.
Futures also have expiration dates, so you need to be careful to roll over or close out positions so not to be stuck with physical delivery of unwanted commodities. To start trading futures, you will need to find a brokerage that offers access to these markets and then get approval.