You might have come across the concept of trading futures when watching TV or reading an article about how to invest money. Although people may understand the basics of investing in stocks and exchange-traded funds, financial instruments such as futures are often more of a mystery.
Understanding the basics of futures is relatively simple, but trading futures can be much more complicated. If you want to learn how trading futures works so you can decide whether opening a futures account is a good fit for you, here’s what you need to know.
What are futures?
Futures are an alternative asset that seem complex but are easy to understand when you break the concept down to the basics. Futures are contracts between you and another entity to buy a set amount of a specific item at a specific price at a particular future date. The items in question could range from precious metals to soybeans. Because futures get their value from an underlying asset, they fall into the asset class called derivatives.
A futures contract spells out the cost of the item, how much you’ll buy or sell, and where you’ll receive delivery of the item if it is a physical commodity. In practice, people rarely take delivery of the item(s) and often settle the contracts for cash instead.
Although futures may have originated with commodities, such as oil, futures exist for investments too. Just as an individual may contract to buy or sell a certain amount of silver in the future, people may also contract to buy or sell investments in a stock index.
Here are some examples of common index futures:
- S&P 500
- FTSE 100
- S&P 500 VIX
- E-mini S&P 500
- E-mini Nasdaq-100
- E-mini Dow
Currencies also have a futures market. These are commonly referred to as forex futures. And these days you can even trade cryptocurrency futures for bitcoin.
How futures work
The futures contracts you hold could increase or decrease in value until the delivery date based on the contract’s pricing. As a futures trader, you can either be the buyer or seller of the item.
Your choice depends on your outlook for the item's price in the future:
- You want to be the buyer on investments you feel are underpriced. If the price goes up, you profit.
- You want to be the seller on assets that you believe are overpriced. If the price goes down, you profit.
You can buy or sell a futures contract at any time trading is active for that contract. The contract has a set expiration date, though. If you’re holding the contract when it expires, it will settle at the current market price. If the contract is for a deliverable instead of settling in cash, you’ll either have to provide or receive the physical goods under the contract.
Here are some common examples of commodity (deliverable) futures:
- Crude oil
- Precious metals
So let’s say you buy a contract to purchase a bushel of corn in February to be delivered in November of the same year. You agree to pay the current market price of $3 for the bushel.
During the growing season, a massive drought occurs. Corn prices increase to $7 per bushel. Because you’ve locked in the low price of $3 per bushel, your futures contract is worth more than when you bought it. A corn-buyer might happily pay you more than you paid for the contract, such as $5, because the underlying asset is now worth more. In this case, you profit because you received more for the contract than you paid for it, but the person taking delivery of the corn also profits because they paid less than the market price.
The opposite could also happen. If the year turns out to be the best corn harvest ever, corn prices may only be $1.50 per bushel in November. In this case, your futures contract would decrease in value. Although someone may be willing to buy the contract because they need the corn, there’s no reason for them to pay more than the current market price of the corn itself. This results in a loss for you.
In practice, people don’t buy a single futures contract. Instead, most investors trade futures on margin. This means they take out debt to invest in a bigger futures position (the amount of an investment you own). In some cases, you’re required to put down only as little as 3% to 12% of the futures contract’s total cost. Contracts that settle with physical delivery require you to pay the remaining amount due at the time of settlement. Cash settlement contracts will automatically settle at expiration at the current market price, leaving you with either a gain or loss.
Trading futures on margin could lead to larger swings in your gains or losses as the value of the contracts change in comparison to purchasing futures without margin. The swings could be massive if the prices on the underlying futures investment change drastically, resulting in very profitable trades if you’re on the right side of the transaction. It could also lead to devastating losses if you’re on the poorly performing side of the transaction.
Futures contracts can provide a valuable trading strategy to companies and investors alike — this is something known as hedging. If an airline knows they’re going to need something in 12 months, such as a certain amount of jet fuel, they could use futures as a way to limit their exposure to price changes over those 12 months. Airlines could lock in a portion of their jet fuel requirement today as a hedge against rising jet fuel prices.
Of course, the airline may not come out ahead. If fuel prices drop, the airline will lose money on the hedge. However, they would have a guarantee that their fuel prices for the quantity their futures contracts specified wouldn’t exceed the amount their contract stated. This could be useful to provide some certainty for budgeting purposes in a highly volatile market.
Pros of trading futures
- Trading can happen at unusual times. Although the stock markets are generally open Monday through Friday from 9:30 a.m. to 4 p.m. EST, futures may trade at different times. For instance, E-mini NASDAQ 100 futures trade on Eastern time from 6 p.m. to 5 p.m. Sunday through Friday with a daily trading halt from 4:15 p.m. to 4:30 p.m. This gives you more time to trade your investments.
- It’s a relatively low cost to get started than some investment types. You don’t have to have $1 million to begin trading futures as you might need when investing with a hedge fund. Many brokerage firms may let you get started in futures trading for around $1,000 or less.
- Leverage could result in higher gains. Because futures are normally traded on margin, you could, in theory, make more money because you borrowed money to get a larger position.
Cons of trading futures
- Trading can happen at unusual times. Although it may seem like a good thing that you can trade futures during most hours, it could also be a drawback. If futures trade overnight while you sleep, you could miss opportunities. You may even wake up to find yourself in a worse position than when you went to sleep.
- Futures may not be SIPC insured. The Securities Investor Protection Corp. insures many investment types in case brokerages fail. (It doesn’t insure investments if they decrease in value, though.) Unfortunately, SIPC insurance doesn’t cover commodity futures contracts except in specific circumstances.
- Leverage could lead to large losses. Although leveraging could help you make more money, it could make your losses larger, too. The small margin requirements for futures could make those losses even more painful than expected for people used to investing with margin for other investment types, such as stocks. This happens because stocks generally require 25% to 40% maintenance margin, whereas futures contracts may only require 3% to 12% maintenance margin.
- Higher minimum investment than investing apps: These days you can open an investment account with a variety of investing apps and trading platforms with no minimum initial investment. This makes the minimum investment many brokerages require for trading futures seem large in comparison.
How to trade futures
Although the underlying concept of how futures work is simple, the act of trading futures is a bit more complex. First, your brokerage must support trading futures. Some major brokerage firms, such as TD Ameritrade (read our TD Ameritrade review for more details), offer this service as part of its brokerage services. Smaller or newer investing apps may not offer trading futures. For your futures broker to be able to trade in the futures exchange, they will need to be registered with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC).
Once you have access to a brokerage account that offers futures, you can start researching which futures you want to trade. This often requires an understanding of charting and a detailed technical analysis of the underlying market for the futures in which you’re interested.
You need to understand the market for the futures item you’re trading and what impacts that particular market as well. For instance, corn futures could be affected by specific market conditions like weather events, diseases, and pests. You may want to pay to access proprietary research or other tools to help you trade futures more profitably.
Make sure you fully understand the impacts of trading futures, the margin requirements, and the potential gains and losses you could incur based on the possible outcomes. Read the information about the specific futures contracts you’ll be trading to understand whether physical delivery is required or if the contract will settle in cash.
How much money do you need to trade futures?
Brokerages may require you to get approval to start futures trading. For instance, TD Ameritrade requires you to have margin approval and a minimum of $1,500 in your trading account. Other brokerage firms may require smaller or larger deposits to start futures trading.
Can you make money trading futures?
As with any investment, you could make money with futures trading. But investing is inherently risky. Past performance can never be taken as a guarantee of future success. In addition, futures trading is generally considered to be riskier and have higher volatility than investing in traditional stocks, ETFs, or mutual funds due to the leverage and contract expiration factors.
Can you buy and sell futures on the same day?
Yes, you could buy and sell futures on the same day. Some day traders buy in futures to attempt to take advantage of small price movements throughout the day. Day trading futures is considered to be even riskier than day trading stocks due to the leverage typically involved in futures transactions.
Futures trading is a much more complicated investment strategy than buying stocks or ETFs, but the basic concepts are relatively simple to understand. Futures trading could be a good option for those looking for a hedge to limit potential exposure to market swings. Expert traders may also view them as a way to take advantage of pricing inconsistencies to make money.
Although all investing is risky, futures trading is even more so due to the leverage involved, especially if you're day trading and looking for short-term returns. Beginner investors and those with a lower risk tolerance might consider focusing on less complex investments such as stocks, ETFs, or mutual funds. Robo-advisors and the best investment apps take this one step further and make investing in ETFs much less time-intensive with the automated tools they offer.
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