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.
In Conclusion
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.