Futures trading has always been popular among traders for its versatility and transparency in the markets. Whether you are looking to manage risk and hedge with a futures contract or hoping to profit from market movements as a speculator, you should make sure you understand how it works before you get started. If you are a beginner trader who is looking to start trading futures, read this guide to learn more about what futures trading is and how you can get started.
What is futures trading?
Futures trading is the buying and selling of futures contracts. These are agreements that legally bind the buyer and seller into buying or selling an asset at a predetermined price at a specified time in the future. Futures trading is done on specialised futures exchanges. Some of the largest ones include the Chicago Mercantile Exchange (CME), the ICE Futures US, the Euronext exchange, and the Tokyo Commodity Exchange (TOCOM).
Common underlying assets in futures trading
Futures trading can provide a great deal of flexibility as traders can trade a wide range of underlying assets. These include agricultural commodities such as soybeans, corn, wheat, and more, as well as energies like crude oil, natural gas, and heating oil. Other underlying assets include metals, currencies, interest rates (via bonds), and stock indices such as the S&P 500, the FTSE 100, and the Nikkei 225.
How futures trading works
Futures trading takes place in futures exchanges. Traders negotiate futures contracts to trade the underlying asset on a predetermined date in the future, at a predetermined price. Hedgers, such as crop growers, use futures contracts to lock in prices to protect them from future market fluctuations. Speculators try to predict price movements of the markets, hoping to make a profit.
Traders will open a futures position by either buying or selling – in other words, they will go long or go short, respectively. They place an order with a broker who then executes it on the exchange on their behalf. When a trader takes a long position, they are agreeing to buy the underlying asset at the predetermined price in the future. They profit if the price rises above that level. When they take a short position, they are agreeing to sell the underlying asset at the predetermined price in the future. They profit if the price falls below that level.
Traders keep their positions open and hope for a favourable price move until the expiry date. They can then offset the position by taking an opposite trade on the same underlying asset, in the same quantity.
Futures traders trade with margin, which is a deposit that is made at the outset to mitigate the risk of a default. If futures contracts reach their expiry dates and the gap between the futures price and the spot price becomes smaller, it is called convergence.
What makes futures trading appealing?
There are several factors that make futures trading appealing to beginner traders. They include the flexibility they offer, the relatively high liquidity of the futures contracts, and the ability to use leverage. The standardisation of futures contracts is also appealing to many traders as it creates a transparency in the exchange.
There is plenty of flexibility in futures trading, as traders can use it in both their hedging and speculation strategies. For example, a crop grower can lock in a price for a specific crop by entering a futures contract, using it as a hedge to protect them from changes in market prices by the time they are ready to sell their crops. Traders can also engage in futures trading as part of their speculation strategy. They speculate on the direction of prices hoping to make a profit when their predictions are realised. This can be a lucrative way to make money, potentially, if their predictions are right.
Futures markets tend to be very liquid. This means that there are many active participants who are looking to buy or sell futures contracts at any given time. This makes it easy for traders to enter and exit contracts quickly, when they can easily find potential buyers and sellers. The high liquidity of futures also means that spreads – the price differences between bid and ask prices – are narrower.
Use of leverage
Futures traders can use leverage when trading to control a large position on the underlying asset without investing a large amount of capital at the outset. This is because only a margin deposit is required. However, while the use of leverage can become a good way for futures traders to potentially increase their profits, it can also pose a greater risk when trading, because losses will be magnified should markets move against the trader.
Finally, futures contracts are standardised. They follow specific contract sizes, expiry dates, and delivery dates depending on the asset that is being traded. This makes them relatively simple and provides a high level of transparency for futures traders, who can easily trade them with peace of mind.
How to choose a broker for futures trading
If you are eager to start futures trading, you can open an account with a regulated broker that operates in your region and offers futures trading. There are some things to consider when you are making your decision, such as:
Commissions and fee structure
You should compare the commissions and fees charged by different brokers as part of the research you undertake when looking for brokers. Not all of them are made the same, and they also may offer sliding scale commissions depending on how much you trade. You should also ensure the broker does not have any hidden fees that can eat into your potential profits, and that you understand any charges they seek, including deposit and withdrawal, overnight financing, and trade execution costs.
Functionality and trading platform
Next, you should think about the trading platform they offer. Make sure they offer one that you will be comfortable with using and have a guide on how to get started. Consider desktop, mobile, and web platforms, and which one suits your lifestyle the best. Choose one that is intuitive and user-friendly. Then, check out the tools offered by the broker on the platform, such as those used for technical analysis, alerts, and order types that can help with risk management.
Education and resources
Next, you should see if the broker offers any education or training sessions that their clients can receive. This can help you level up your trading skills as you progress. Brokers that provide frequent market updates and alerts can also help you stay on top of markets.
Quality and speed of trade execution
You should consider the speed and quality of trade execution – which is how quickly you can open and close trades and enter and exit contracts. Of course, this depends on the market in which you are trading and the liquidity of the asset. However, a good broker will have multiple servers and low latency when executing trades to minimise the potential for slippage. You can specifically check out fill rates between brokers to evaluate this.
You should also check out what others are saying about the broker on the Internet. Peer reviews are often great sources of information, and you can see how strong their platform and customer support teams are when you see how their customers have been treated in the past and how they have fared.
The bottom line
At the end of the day, futures trading can potentially be a lucrative way to make money on the markets. Whether you are a hedger or a speculator, you should remember that it also comes with risks, and you should never trade with more money than you can afford to lose. If you are eager to start trading futures, you should always conduct thorough research and ensure you know how the market works before you invest your real money.