Trading futures involves tracking trends and anticipating price movements. This market might offer certain advantages, depending on how you trade.
Every now and then, you might meet a new coworker who fidgets during training for his new position, clearly eager to say something. Other coworkers patiently explain each of the new hire’s responsibilities to him, even when he might seem distracted. Finally, they ask the new employee if he has any questions.
“Yes, I do. These systems may work this week, but what about six months from now? Shouldn’t we be thinking ahead?”
This is the type of person who is constantly watching trends and anticipating the next move — in fact, you might even be this person. If you know a trader like this, he might be attracted to futures trading.
Traders in the futures market rely on an understanding of the assets they trade as well as technical and fundamental analysis for their markets. With enough research, futures traders hope to detect substantial market swings, such as negative oil prices in 2020, early enough to make a profit. However, these kinds of trades also involve certain risks.
Here’s how it works.
READING THE TEA LEAVES
Trading futures does not necessarily mean trading in shares like stocks. Instead, the futures market trades with contracts on an exchange.
A futures contract is an agreement to buy or sell a commodity on an agreed date in the future. Both the buyer and seller are obligated to complete the trade by the time the contract expires. The contract usually specifies the number of goods, the means of delivery (whether there is a physical delivery or a cash settlement), the asset’s unit of measurement (such as ounce, ton, or barrel), and the currency used in the transaction.
Futures contracts allow investors to speculate on the direction of an asset by going long or short. Since most futures trades are speculative, traders can hedge the price movement of the asset to potentially limit losses.
We can characterize the types of futures contracts by two comprehensive categories: commodity and financial.
- Energy (crude oil, natural gas)
- Metals (gold, silver, platinum)
- Agriculture (grains, livestock)
- Interest rates (treasury bills, treasury bonds, Eurodollars)
- Forex (foreign exchange of currencies)
- Equity indices (S&P 500, Russell 2000, NASDAQ)
SEEING A SIGN OF THINGS TO COME
One of the most popular strategies for futures trading is anticipating the direction of the price and buying or selling accordingly. However, unlike folkloric fortune tellers, we don’t have access to crystal balls that can show us the future of our investments. Instead, many traders rely on technical and/or fundamental analysis to help inform their decisions. By studying charts and indicators, traders can identify price patterns that may signal where the price of that asset is likely to go.
Traders may also use a credit spread for their approach. A credit spread is an options strategy that involves simultaneously buying and selling options of the same class (meaning put or call) and the same expiration date, but with different strike prices. This means that when traders enter the position, they receive a net credit, and if the spread narrows, they profit.
For example, a trader might try a credit spread by buying a contract for one month and selling a contract for a later month. In this multi-leg option strategy, the trader benefits from a change in price between those months. There might be a loss on one leg of the spread but a profit on the other leg; ideally, the profit outweighs the loss.
COUNTING CHICKENS BEFORE THEY HATCH
Depending on your priorities, futures trading may offer certain advantages. For one, the futures market trades a substantial number of contracts every day, which improves its liquidity. And unlike other day traders, futures trading is not subject to the pattern day trading rule.
Traders can also trade futures 24 hours a day, six days a week. Futures are available after regular hours, which might appeal to those whose schedules prevent trading during traditional market hours.
Moreover, futures traders may trade on margin, meaning they have the potential to increase their profits because they have access to a great value of assets.* Margin rates for futures vary depending on your broker.
On the other hand, the factors that attract certain investors may also have some disadvantages. With more margin borrowing and higher leverage, investors expose themselves to more risk. As the potential for risk escalates, investors should develop a risk management strategy that works for their tolerance. No matter how promising certain trades may seem, there is no crystal ball that can fully protect traders from risk.
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*Effect of “Leverage” or “Gearing”
Transactions in futures carry a high degree of risk. The amount of initial margin is small relative to the value of the futures contract so that transactions are “leveraged” or “geared.” A relatively small market movement will have a proportionately large impact on the funds you have deposited or will have to deposit. This may work against you as well as for you. You may sustain a total loss of initial margin funds and any additional funds deposited with the firm to maintain your position. If you fail to comply with a request for additional funds within the time prescribed, your position may be liquidated at a loss and you will be liable for any resulting deficit.