How to Research and Choose Futures Contracts

In futures trading, success can bring you significant profits, but mistakes can be costly. Different types of futures contracts have distinctive features, though they are always an agreement to buy or sell an underlying asset at a specified price on a predetermined date. 

Experienced futures traders might focus on a few markets that they trade often, allowing them to have a deeper understanding of the contracts and make informed decisions. 

For new traders, knowing which futures contracts to choose can be challenging. Having a selection process is a necessary step to master to become a successful future trader.  In this article, Benzinga explores how to research and choose futures contracts to trade for your investment strategy.

How to Research and Choose Futures Contracts

Before you start trading, you may want to evaluate the following features when researching futures contracts.

1. Unique Traits of the Asset

Before trading a futures contract, the first consideration is what type of asset you are trading and its unique characteristics. Futures contracts derive their value from an underlying asset, and pricing may be affected by economic cycles or news. The futures contract price may also move in tandem with other similar assets. For example, agricultural resources that are in demand may have similar trajectories.

In some markets (like currencies), speculation, instead of economic indicators, drives prices, which means traders may prefer to close out their positions before the contract expires. In other markets like agricultural futures, weather conditions or trade embargoes affect prices. 

For example, if you are trading currency futures, you can pay attention to central bank policy statements, macroeconomic reports or the effect of oil prices on an economy. Having prior knowledge and experience in a particular underlying asset or futures market can help you choose the futures contracts to trade. You can also start to follow futures markets if you want to expand your futures investing portfolio.

2. Margin Requirements

Margin is the amount of cash you need to maintain in your account while your futures contracts positions are open. Margin requirements vary by brokerage. Any unused margin stays in your trading account when the contract expires and the trade is settled. 

A margin call is initiated when your account balance falls below the margin requirement. When this happens, you must fund your trading account to re-establish the required margin level or your position may be closed. To avoid a margin call, it is advisable to fund your trading account with capital in excess of your broker's margin requirement. 

3. Spread

The spread is the difference between the bid and ask for the futures contract. It determines how expensive it is to enter or exit a futures contract. 

Taking note of the spread enables you to determine how difficult it is to get in and out of a trade. Margins on spreads are usually minimal in futures markets, but securities that have low trading volumes usually have wider spreads.

The more popular or widely traded a futures contract is, the tighter the bid-ask spread will be. For example, if you are trading S&P 500 equity index futures contracts, you will likely see much tighter spreads than if you trade an emerging market futures contract that has fewer market participants. 

4. Liquidity

Liquidity indicates how easy it is to buy or sell your security through volumes and order book depth. In futures trading, liquidity reflects the trading interest in a contract and the efficiency at which it can be bought and sold. If large numbers of futures contracts are available to trade in the market, you have access to reasonable liquidity. Looking out for liquidity gives you an idea of how expensive it is to trade because liquidity can impact how wide or tight a spread is. 

5. Trading Time

Unlike stocks, all futures markets do not trade at the same time. Trading times depend on the market or security you are trading. This difference in trading time adds to the complexity of futures contracts. 

For example, while agriculture futures trade Sunday to Friday from 19:00 to 07:45 and 08:30 to 13:20 (CT), trading on cattle futures contracts is between 08:30 to 13:05 (CT).

Added to this, the trading time on a particular contract can change. Though markets like the Chicago Mercantile Exchange (CME) announce changes in trading time months before, brokerages don't. So it's your responsibility as a trader to keep track of potential changes in trading time. 

Benefits of Futures Investing

You will find several benefits with futures trading. Let's take a look at some of them. 

Hedging: Futures investing is an important tool for risk management. For example in the currency market, investors can use futures to hedge the risk of currency fluctuations. Companies engaged in foreign trade use futures to manage foreign exchange risk or interest rate risk by locking prices to be bought or sold in the future. This practice protects them from price changes that may result before the contract expires.

Taxes: Investing in futures has potential tax benefits for short-term gains when compared to other assets like stocks. Profits on futures trades are taxed on a 60/40 basis. This means 60% of profits are taxed as long-term capital gains, while the remaining 40% is taxed as ordinary income. Capital gains on stocks held less than a year are taxed 100% as ordinary income. Ordinary income rates are typically higher than capital gains tax rates.

Lower commissions: Brokerage commissions on future trades are usually fairly low, with brokerages often charging under $1 per contract. However, be sure to compare brokers to get the best deal, as commission rates vary.

Considerations When Researching Futures

When you research futures trading strategies, you need to look at a few factors.

Futures market: The futures market you choose to trade in depends on your knowledge, expertise and experience. Underlying assets can vary from equities to bonds to other less commonly traded assets. If you don’t understand the dynamics of the underlying market, it may be difficult to trade the futures contracts well. 

Complexity: Some futures contracts are more complex to trade than others. This complexity may be from time, spread or characteristics of the asset class. For example, trading stock index futures may be easier than trading agricultural futures like cattle. 

Expiry dates: Futures contracts have expiry dates that may be monthly, quarterly or on a seasonal basis. Knowing the expiry date helps you plan your trades, especially when it comes to entry and exit strategies. 

Trading strategy: Your trading strategy helps to define your parameters for entering and exiting trades. There are a variety of styles to choose from. Will you be day trading futures? Will you embark upon futures spread trading or futures options trading? Having a clear plan is essential in building a solid foundation from which to work.

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