What are futures contracts?
Futures contracts are agreements to buy or sell a certain asset at a specific date and price. Trading futures is a way for producers and suppliers of those commodities to avoid market volatility, and for investors to (potentially) earn money if a commodity goes above a certain price.
In addition, supply and demand determine the prices of commodities, and standardized contracts help ensure the stability of the futures market.
What is the futures market?
Futures markets are places where one can buy and sell futures contracts. The New York Mercantile Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, the Chicago Climate Futures Exchange, the Kansas City Board of Trade and the Minneapolis Grain Exchange are a few well-known examples.
To make these abstract “contracts” seem more tangible, commodities such as the following are traded on the market:
- Crude oil
Of course, there are many more kinds of assets, including stocks, indices, commodities and currency pairs; commodities aren’t the only types available.
Steps to learning to trade futures
Perhaps the most important step in learning to trade futures is to learn everything you can about futures. Understand the word derivative. Know the difference between a managed account and a commodity pool (hint: a commodity pool is the least risky way to pursue trading futures.) Know what a hedger does compared to a speculator.
That said, here are a few steps you should take if you’re interested in learning how to trade futures:
Understand the risks
Leverage is one of the major risks involved with futures trading, as traders can leverage up to 90 to 95 percent and not put up very much at all of their own money. Traders can therefore sustain huge losses or large gains, depending on the success of their trades.
There are also distinct advantages to futures trading:
- It allows hedgers to shift risks to speculators.
- It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.
- Based on the current future price, it helps in determining the future demand and supply of the shares.
- Since futures are based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin instead of the entire value of physical holdings.
Choose a method
DIY: You can do it yourself with your choice of broker.
Managed account: You can take advantage of a managed account; these are managed by professional investment management companies known as commodity trading advisors who specialize in these trades.
Choose a broker
It’s important to make sure you’re using a licensed, secure broker. We’ve done the hard work fo you. Check out Benzinga’s Best Brokers for Futures Traders for a full list.
You’ll be able to make an initial margin deposit with the broker you’ve chosen, and the broker will place the trade. A maintenance margin is required in order to keep your account active. Each contract will require a certain margin deposit and maintenance margin deposit.
Get to know your trading platform
One of the most important components of learning to trade futures is to be sure you know your trading platform well. It’s easy to lose out if you’re not sure how to use your trading platform.
Develop a trading strategy
Novice traders sometimes make a huge mistake by not developing a trading plan before they trade. A trading plan defines your goals, willingness to take risks, objectives and overall strategy. Your plan should be detailed, including what you’ll do hour-by-hour as you trade. You’ll then be able to closely monitor your performance and can even clearly articulate your exit strategy for losing trades.
Choose your contracts
This can be one of the most challenging aspects of learning to trade futures. Here are some questions to ask yourself:
- What is the margin requirement?
- What is the spread, or the price difference between the bid and ask?
- How liquid is the contract? (The more liquid it is, the less it will cost for a contract to enter and exit the market.)
- How consistent is the daily volume? Volume fluctuations or inconsistencies above or below the historic average can be an indicator of price movement.
There’s no better hands-on way to learn futures trading than by backtesting. It’s a great way to get a sense of the market, help you with trading indicators, and above all, hone your strategy. It’ll show you how your contract may perform in an actual trading environment.
While backtesting, you’ll be able to decide on a set of parameters for entrance and exit and ultimately, you’ll be able to automate your trading strategy.
When you’re ready to place an order, you’ll contact your broker, all the while specifying the details of your order, including expiration date, contract size, etc.
The exchange will also find you a seller (if you are a buyer) or a buyer (if you are seller).
Selling futures contracts
There are some advantages to trading futures, and that includes the ability to buy long and sell short easily. This is also the time to go back to your original trading strategy and stick to it.
This diagram showcases a step-by-step overview of how to handle stock futures trades on expiration and before expiration:
Keep in mind that you can’t back out of a futures contract if the price goes in the opposite direction. If the market price on the date of the expiry is below the price of the contract, you’ll have to pay the additional amount and accept a loss.
Ultimately, in futures trading, it’s imperative to control your risk. When it comes down to it, in trading you only have real control over two things: your entry and your exit. The difference between the two is your risk. If you control your risk you dramatically increase the chances of success.