by Amanda Harvey
What are Futures?
When trading futures, the initial step is the setting up of a futures contract. This is a financial trading agreement which obligates the buyer to buy a certain amount of an asset at a predetermined price at a specific future date, and requires the seller to deliver the asset on the specified date at the agreed price.
As well as trading futures on commodities, futures can be traded on a range of stocks and bonds.
It is important to understand that a futures contract has no innate value in itself, and whether it will result in a profit or a loss to the trader depends on the price movement of the underlying asset which will be bought or sold on expiration of the contract.
Futures contracts have varying lengths of duration, with the most common length of contract being three months, however, there are futures contracts available that expire in shorter periods. Futures contracts are traded on futures exchanges.
How Futures Contracts are Traded
One important aspect of the trading of futures contracts is their function in reducing the risk of default by either party before the date of expiration or settlement. In order to fulfill this purpose of risk mitigation, the futures exchange on which the contract is traded requires a cash amount, known as margin, be deposited into a margin account by both the buyer and the seller. This margin must be maintained for the life of the futures contract as a guarantee that the contract will be honored.
Upon expiration, the contract is settled in one of two ways, according to the specifications of the contract. The two methods of settlement are physical delivery and cash settlement. Physical delivery is the actual receiving of the asset, such as commodities or bonds by the buyer. Cash settlement is used in areas such as stocks, where the difference between the market price and the price of the contract is paid to the appropriate party, depending on which way the outcome has resulted.
Purpose of Trading Futures
As with most forms of trading, futures can be traded with two basic intentions. The first is as a means of hedging against anticipated price movements. One example is an airline buying futures in oil to protect against a surge in price. The risk in this strategy is that if the price drops substantially, the airline may find it hard to offer competitive rates while still covering the cost that they have paid for fuel, while other airlines are purchasing at market prices.
The other purpose of trading futures is speculating on the movement of a market price making the asset purchased with a futures contract worth more than what was paid for it, thereby generating a profit.
The Risk of Trading Futures
While there is a certain amount of risk involved in any type of trading, futures trading has a reputation for being an especially risky area. One reason that trading futures can be riskier than trading stocks is the application of leverage in a margin account. What this means is that a trader is trading amounts that are greater than their actual capital. With a stock margin account, the leverage is generally 50% margin. What this translates to is being able to trade $30000 worth of stocks with $15000 in the account. If the trader was to lose everything on this trade, they would end up owing $15000.
This risk is multiplied in the case of trading commodity futures. A trader can typically trade commodities on 5% margin, which in the above example of an account with $15000, means that they can trade a huge $300000 worth of commodity futures. While this could result in a huge gain on a relatively small amount of capital, it could also translate into financial ruin if the outcome is unfavorable for the trader. The obvious way to avoid this amplified risk is to trade with a lot smaller percentage of borrowed money, or even to steer clear of trading leverage in a margin account at all.
While trading futures is a potentially profitable form of trading, it is important to have a solid understanding of the ins and outs of the futures market and the possible risks involved in this type of trading before adding futures to your investment plans.