August 30,2024 @10:48 AM
There is a futures contract for almost anything that you can imagine—from crude oil prices and central bank interest rates to the value of cryptocurrencies like Bitcoin. Futures contracts provide traders with a platform to hedge risk and speculate on price movements for a wide variety of assets.
Whether you’re a farmer looking to lock in crop prices, an airline trying to manage fuel price volatility, or an investor speculating on stock index movements, futures markets can present traders with the tools to manage risk and take advantage of opportunities. However, understanding how these contracts work and how to navigate the markets can be overwhelming for beginners.
In this piece, we aim to demystify the basics of futures trading. At EdgeClear, we strive to empower traders with the tools and resources needed to navigate the markets confidently, regardless of experience level.
What Are Futures?
A futures contract is an agreement to buy or sell a specific asset at a predetermined time on a set future date. These contracts play a vital role within financial markets, as they enable participants to hedge against price changes or speculate on future price movements. Futures contracts can involve a wide range of assets, including commodities, currencies, and financial instruments.
Purpose of Futures Contracts
Futures contracts serve two main purposes: hedging and speculation.
Hedging is used to reduce the exposure associated with the price of an asset by taking the offsetting positions within it. For example: A soybean farmer uses a futures contract to lock in a short contract of $12.00 per bushel to protect against any potential price drops before harvest. This ensures that the farmer gets a stable price, regardless of market fluctuations. If the physical price of soybeans decreases, the farmer will generate revenue on his/her short position. If the price rises, the farmer will generate revenue on the physical product.
On the other hand, speculation is used by traders that are attempting to make a profit from a contract’s expected price changes. Most traders in the market are speculators. This means that a trader makes a decision as to where they believe the market is heading. Speculation holds more risk than hedging, as it is vulnerable to both the downside and the upside of the market, however, when they win, a trader can make a significant profit. For example: An investor buys a futures contract for The E-mini S&P 500 at $5000, anticipating that the price will rise. If the E-mini S&P 500’s price increases to $5100, the investor can sell the contract at a higher price for a profit.* On the other hand, if the price were to drop, the investor may face a significant loss. Please note that trades are subject to fees and commissions.
*Please note that the price of the E-mini S&P 500 is constantly fluctuating. To find real-time pricing, check the CME Group or contact an EdgeClear broker.
Types of Futures Contracts
- Commodity Futures: These are contracts that are linked to a physical asset that can be bought and sold by investors. Some of these commodities include: agricultural products, metals, and energy resources.
- Financial Futures: Contracts within this scope are based on financial instruments and indices, rather than physical goods. For instance, there are contracts based on the S&P 500 Index that allow for investors to hedge against or speculate on movements within the U.S. stock market.
- Currency Futures: These contracts depend on foreign exchange rates for future dates. An example of this would be the Euro futures contract, which is based on the value of the Euro against the United States dollar.
How Futures Markets Work
Futures contracts are initiated through a standard agreement between two parties. Once the contract is bought or sold, it is traded on the futures exchange. Some of the key features you should understand include:
- Margin Requirements — Margin is the amount of money that is needed to open and maintain a futures position. It is set to ensure that a trader can meet a contract’s obligations and pay off any potential losses. There are three types of margin funds that you will be responsible for when trading futures:
- Initial Margin — Consider initial margin as your “down payment” that is needed to open a futures position. The amount that you will pay is set by the exchange as a percentage of the contract’s value. On average, the exchange will set the initial margin requirements between 3% and 12% of the contract’s notional value.
- Maintenance Margin — This is the amount that needs to be maintained within your trading account to keep your position open. If your account balance were to drop below this set level, you would receive a margin call notifying you to deposit additional funds to bring your account back up to the necessary margin level.
- Day Trading Margins — Brokerage firms typically set their own margin requirements. These are often lower than the CME’s initial margins and provide traders with increased leverage to trade.
- Initial Margin — Consider initial margin as your “down payment” that is needed to open a futures position. The amount that you will pay is set by the exchange as a percentage of the contract’s value. On average, the exchange will set the initial margin requirements between 3% and 12% of the contract’s notional value.
- Leverage — Since you can buy futures products with as little as 5% of the notional value of the contract, this gives trader’s the ability to control a large position with a relatively small amount of capital. There is a significant amount of power that leverage holds, with associated risks and benefits. Remember, leverage amplifies both potential gains and losses and may not be suitable for all investors.
- Example: Imagine being offered the chance to buy $260,000 worth of Apple stock with only $1,000 in your account. Would you take it? Now, consider this: if the stock’s value dropped to $0, you would be responsible for repaying the entire $259,000 difference. How would that impact your decision?
- The above question is a good example of the power leverage entails. The E-mini S&P 500 is trading at about 5200.00 (as of 8/13/2024) and each contract is worth $50 x the Index Value. Meaning, the total value for one E-mini S&P 500 futures contract is approximately $260,000. Want to learn more about margins? Read all about it on our Knowledge Base!
- The above question is a good example of the power leverage entails. The E-mini S&P 500 is trading at about 5200.00 (as of 8/13/2024) and each contract is worth $50 x the Index Value. Meaning, the total value for one E-mini S&P 500 futures contract is approximately $260,000. Want to learn more about margins? Read all about it on our Knowledge Base!
- Example: Imagine being offered the chance to buy $260,000 worth of Apple stock with only $1,000 in your account. Would you take it? Now, consider this: if the stock’s value dropped to $0, you would be responsible for repaying the entire $259,000 difference. How would that impact your decision?
- Mark-to-Market — This means that the value of the contracts is recalculated at the close of each trading day based on the settlement price of the contract. Any gain or loss in the contract’s value is credited or debited to the trader’s account, ensuring that their margin balance accurately reflects the current market value of their positions. This process helps manage risk by ensuring that traders have sufficient funds to cover potential losses, thereby maintaining the integrity and stability of the market.
- Settlement — At the end of a contract’s term, the asset can be settled in one of two ways:
- Physical Delivery: This means that the physical asset specified within the contract will be delivered to the buyer. For example, if a futures contract is for 100 ounces of gold, the seller must deliver 100 ounces of gold to the buyer.
- Financially Settled: Settling in this way means that no physical asset is delivered, instead the contract is settled in cash from the purchase/selling price. When a cash settled futures contract meets the contract’s expiration, it converts directly into cash. For instance, the E-Mini S&P 500 ES is a prime example of a financially settled product that uses the final settlement price.
How To Trade Futures
There are several ways that a trader can be involved in global commodities through the futures markets:
- Self-Directed Trading: This approach is favored by many experienced traders who prefer to manage their trades independently. Self-directed trading involves analyzing market news and data, utilizing advanced charting and analytics tools, and executing trades on your own.
Looking for a tool to assist your trades? We have developed EdgeWatch: a free trade analyzing tool that allows you to track performance, organize trades, get access to advanced statistics, and more! Please note that while the platform itself is free, you have to purchase the Rithmic data feed to apply our plug-in tool. Check out EdgeWatch’s features and schedule a consultation here.
- Automated Trading Systems: These systems utilize algorithmic data to autonomously execute trades based on a trader’s predefined criteria. They have the ability to process large amounts of market data and execute trades efficiently without emotions within a quick time frame, taking advantage of market opportunities. This method of trading may be suitable for traders that are looking to leverage machine-learning technology without frequent manual oversight.
We are thrilled to offer traders two high-performance quant-driven automated trading programs: EdgeQX and EdgeQX-R. Both programs include long and short signals, allowing for the system to strike on intraday market opportunities. These programs are constantly adapting and changing to align with real-world market conditions and are overseen by our team of trading professionals. Schedule a consultation with our tech experts today!
- Managed Futures: Managed futures involve investing in futures contracts that are overseen by a commodity trading advisor (CTA) or Commodity Pool Operator (CPO). They will handle all trading decisions on your behalf. This is a much more hands-off approach, allowing the CTA to use their industry experience to manage risk, diversify your portfolio, and execute trades effectively.
- Broker-Assisted Trading: This involves working with experienced brokers that can provide guidance and support. Every market day, brokers are there to assist you with trade execution and risk management, all personalized to your trading preferences. Broker-assisted trading can be beneficial for traders, as they have direct contact with an industry expert that is there to help them navigate the complexities of the futures market. However, the cost is traditionally higher for this suite of services.
At EdgeClear, every trader benefits from their own personal broker that is dedicated to their goals. Available Monday through Friday during US trading hours, our team provides tailored support to help you on your trading journey. Plus, our overnight risk desk team is ready to assist with any urgent live trading needs. Curious to find out more? Contact our team here.
Risks and Benefits of Trading Futures
Trading futures contracts can offer traders unique opportunities, including profit and risk management, but it also comes with its own set of challenges. Having a strong understanding of both the potential benefits and risks can help you to make well-informed decisions and manage your positions more practically.
Benefits
- Regulation and Transparency: Most futures markets are under strict regulatory powers including the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). This regulation ensures that fair and transparent practices are in place for all traders.
- Diversification: There are a great deal of opportunities for futures traders to diversify their portfolio across different asset classes. Having a diverse portfolio enables traders to manage risk within different markets and asset types.
- Centralized Markets: Most futures markets are centralized, meaning trades are all executed within a regulated exchange with multiple layers. The CME for example offers redundancies. The exchange guarantees the clearing house, the clearing house guarantees the FCM, the FCM guarantees the IB, and the IB guarantees the customer. Being involved in centralized markets provides market participants with a high level of market integrity, greater transparency, and reduced risk.
- CME Clearing acts as the buyer for every seller and the seller for every buyer for every trade. You do not have to worry about the other end of your trade falling through, because CME Clearing is always on the other end.
- CME Clearing acts as the buyer for every seller and the seller for every buyer for every trade. You do not have to worry about the other end of your trade falling through, because CME Clearing is always on the other end.
- Leverage: As previously noted, leverage allows for a trader to control a large position with a small amount of capital. This can be used to amplify gains, earning notable returns with a small initial investment. Please read below to understand the risks of leverage.
Risks
- Uncertainty: You don’t have any control over future events, as many factors come into play with an asset’s cost. Some of these factors include natural disasters, poor weather conditions, political tension, and more.
- Complex Concepts: Trading futures involves a handful of complex strategies and features. Having a strong grasp on the mechanics of the futures industry can be challenging, especially for beginners. As a trader, you must remain up-to-date and informed with the industry and its evolution over time.
- Leverage: While you may be able to garner significant gains with leverage, this also magnifies losses. You should be aware of the risks that are associated with leverage and have risk management strategies set in place to address any potential challenges. Investors can lose all, or more than their initial investment.
Navigating the Futures Market: Your Next Steps
As you journey further into the world of futures trading, keep in mind that reaching consistent profitability requires both a deep understanding and practical experience—it doesn’t happen overnight. There are many complexities to the industry that seem daunting, but with the right tools, resources, and support they can become more manageable.
The whole EdgeClear team is dedicated to helping ease any roadblocks you may face. Regardless of what trading approach and assets you decide to trade, our goal remains the same: to empower you to reach your trading goals.
Don’t be afraid to jump into the deep end. Embrace the foundational importance of the learning process, seek out resources, and stay informed with industry trends. With your dedication and the right support, you will be well-equipped to navigate the complexities of futures trading and work towards achieving your trading goals.
Derivatives trading involves a substantial risk of loss and is not suitable for all investors.
