Investors can trade futures to speculate or hedge on the price direction of a security, commodity, or financial instrument. To do this, traders purchase a futures contract, which is a legal agreement to buy or sell an asset at a predetermined price at a specified time in the future. Futures came about in the mid-19th century, allowing grain farmers to sell their wheat for forward delivery. Futures trading provides investors with a fast and cost-effective means of accessing global financial and commodity markets.
- Investors can trade futures to speculate or hedge on the price direction of a security, commodity, or financial instrument.
- 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.
- Key futures markets include stock indexes, energy, currencies, cryptocurrencies, interest rates, grains, forestry, and livestock.
- Key advantages of futures trading include access to leverage, diversification, and hedging, while overleverage and managing expiry dates present potential challenges.
- A futures trading platform should be intuitive to use, offer multiple order types, and have competitive fees and commissions.
- A basic futures trading plan should include entry and exit strategies as well as risk management rules.
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 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, forest, 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.
Advantages and Disadvantages of Futures Trading
Leverage: Futures are traded 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 24 hours a day. For example, a trader may wish to go 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.
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 contract to a longer-dated one as the expiry date approaches.
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.
Selecting a Futures Trading Platform
When selecting a futures trading platform, investors should ensure that it is intuitive to use, offers multiple order types to help with risk management, and 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 you execute trades and manage positions on the go.
Developing a Futures Trading Plan
As with trading stocks or other financial assets, it's important that investors develop a plan for trading futures that outlines entry and exit strategies as well as risk management rules. For example, 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.
Alternatively, a futures trading plan 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.
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 CME as an example.
Contract Size: As its name suggests, 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 simply 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 is trading at $4,800. This means the contract value equals $240,000 ($50 x $4,800).
Tick Size: 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).
Putting It All Together
Let's put it all together in a trading example using the E-mini S&P 500 futures. The S&P 500 index recently broke out to a new all-time high, and we'd like to fade the move, hoping to book profits on a retracement to the initial breakout area around $4,720. Our money management rules stimulate that we risk no more than 1% of our futures trading account on any one trade. Additionally, our broker requires a margin of $12,000.
Therefore, 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 at $4,786. As we are risking $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 ($1,250 risk per contract versus $3,300 reward per contract).
What assets can be traded using futures?
Investors can trade futures on stock indexes, energy, currencies, cryptocurrencies, interest rates, grains, forestry, and livestock.
What are the key advantages and disadvantages of trading futures?
Advantages include leverage, diversification, trading after hours, and hedging. Disadvantages include over-leverage and managing expiry dates.
What should I look out for when selecting a futures trading platform?
Traders should select a futures trading platform that is intuitive to use, offers multiple order types, and has competitive fees and commissions.
What are some basics to include in a futures trading plan?
When developing a futures trading plan, traders should include entry and exit strategies and basic risk management rules.