What is Futures Trading and How Does It Work?

Futures are contracts obligating the buyer to purchase or the seller to sell an asset at a set future date and price. Learn how they work.

If you know about trading or are involved in trading, you probably know about futures and options. Futures and options are the most traded tools for active traders nowadays. But before understanding futures trading, you should know what futures are. 

Futures are financial instruments used in trading and investing. They obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. And futures trading is a trading method involving a contractual agreement between parties to buy or sell a specific asset at a predetermined price on a future date. This contractual obligation, known as a futures contract, is traded on organized exchanges.

Futures trading is used in speculation; it provides traders and investors with a platform to speculate on the future price of an underlying asset, which can be any asset, such as stocks, crypto, commodities, forex, etc.

What are futures in simple terms?

A futures contract is like a formal agreement where two parties decide to buy or sell a specific amount of an asset at a fixed price on a set future date. This contract is legally binding, meaning both sides have to follow through. The buyer agrees to purchase the asset at the agreed price, while the seller promises to deliver the asset or its cash value.

For example, let’s say a farmer expects a bumper crop of wheat for the season he planted, and he wants to protect his crop against price decline; what the farmer can do here is enter into a futures contract to sell the wheat at a specific price at a future date. So he can lock in the present price so if the price declines, he can sell at the locked price.

What are the Key Components of a Futures Contract?

Key components of futures contracts are:

1. Underlying Assets: Futures are derivatives of the spot assets; according to the price movement of the spot, futures move in conjunction. The underlying Asset can be a physical commodity, a financial instrument, or a stock index. The specific characteristics of the underlying asset significantly influence the contract’s value and risk profile.
   
2. Contract Size: Contract size is the standardized quantity of the underlying asset specified in the contract. Usually, there are 100 shares in a contract size. The standardized units help in uniformity and ease in trading.
   
3. Expiration Date: The predetermined date is when the futures contract matures, and the buyer is obligated to take delivery of the underlying asset or settle the contract for cash. Futures contracts have specific expiration dates, and their time to maturity influences their price and volatility.
   
4. Price: The agreed-upon price at which the underlying asset will be exchanged on the contract’s expiration date. This price is determined by market forces and fluctuates continuously based on supply and demand dynamics.
   
5. Margin Requirements: To participate in futures trading, traders are required to deposit a margin, which is a fraction of the contract’s total value. This margin guarantees the trader’s financial commitment and helps mitigate counterparty risk. It’s essential to note that margin requirements can fluctuate based on market volatility.

What are the Types of Futures Contracts?

Types of futures contracts are:

1. Commodity Futures: Physical commodities like agricultural products, energy resources or the most famous gold come under the commodity’s futures. These future contracts are widely used by producers, consumers, and speculators to manage the price risk and to benefit from price fluctuations.
   
2. Financial Futures: These contracts are derived from financial instruments, including stocks, bonds, currencies, and interest rates. Financial future contracts are the most used instruments used by speculative traders. Financial futures are used to hedge against market risks, speculate on interest rate movements, or manage currency exposure.
   
3. Index Futures: Index futures, like the S&P 500 and Nasdaq 100, track the movements of the index spot. With index futures, you can have exposure to the overall market with a single contract. 

4. Currency Futures: Currency future contracts allow you to speculate on exchange rate movements between different currencies. The currency futures are used in speculations as well as managing the currency risk for corporations, importers, exporters and investors.

What are the Benefits and Risks of Futures Trading?

Benefits

1. Leverage: It is not possible for every trade to have a big account size; future contracts provide traders with leverage so they can increase their profit potential. Leverage in futures is different by region, and the specific asset also decides the leverage in contracts. By depositing a relatively small margin ranging from 3-12%, traders can control larger contracts. However, remember that leverage is a double-edged sword. It can increase profit as well as increase losses and wipe your capital.
   
2. Hedging: To protect the downside of any investment, investors usually sell future contracts of the underlying asset so the risk can be managed with the investment’s downside and profit from the sale of the future. 

For instance, an airline can hedge against rising fuel costs by purchasing fuel futures. Or let’s say you buy NVIDIA shares and expect the price to go down in the coming times to minimize the risk you sell NVIDIA futures so you can gain from these contracts.

3. Liquidity: Futures markets are characterized by high liquidity, ensuring that traders can easily enter and exit positions without significant price impacts. This liquidity is essential for effective risk management and trade execution.
   
   Futures trading also expands investment possibilities beyond traditional stocks and bonds. By incorporating futures contracts into a portfolio, investors can diversify their holdings and potentially enhance returns.

Risks

1. High Leverage: As I told you earlier, futures with increasing profits can equally increase losses. There can be huge price swings, and if you have a leverage position size, this can erode your capital in minutes, and you can be on your financial back foot. So, while using leverage, make sure to use proper risk management techniques.

2. Market Risk: Future contracts are usually more costly than a single unit of stocks, and market volatility can erase your capital with the big position sizing. Markets are known for their volatility, with prices fluctuating rapidly. This volatility can create both opportunities and challenges for traders.
   
3. Margin Calls: To maintain a futures position, traders must meet specific margin requirements. If the market moves against a trader’s position and the account balance falls below the maintenance margin, a margin call is issued, demanding additional funds to be deposited. Failure to meet a margin call can result in liquidation of the position.

How to Trade Futures?

Here is the step-by-step procedure to trade futures:

Step 1: Choose a Market

Before you start trading futures, you have to decide which markets to trade. You can choose from various futures markets, such as stocks, commodities, forex, etc. The market you are choosing should be aligned with your trading objectives and risk tolerance. Before choosing any asset, analyze the factors such as your understanding of the underlying asset, market liquidity, and volatility. 

Step 2: Analyze the Market: According to your strategy, either technical analysis  (chart patterns, indicators) or fundamental analysis (economic indicators, company performance), you have to analyze the market to find trading opportunities. 

Step 3: Place a Trade

To place a trade, you need a broker account, which will place your trades in exchanges. You can find various brokers online and register with an easy process. Once you’ve conducted your analysis and identified a potential trading opportunity, you can place a futures order. 

Step 4: Manage the Position

Effective risk management is the key to successful trading. You can use various risk management techniques, like employing stop-loss orders to limit potential losses if the market moves against your position, taking partial profit if the contracts are in your direction, etc. Continuously monitor market conditions and be prepared to adjust your position based on changing circumstances.

Step 5: Close the Position

To close your futures position, you’ll need to make an opposite trade. For example, if you bought a futures contract, you would close it by selling the same contract. Your profit or loss is the difference between the price when you entered and the price when you closed the position.

What are futures vs stocks?

Futures and stocks are both traded on exchanges but are fundamentally different investment options with unique characteristics, risks, and rewards.

Key Differences:

• Ownership: Buying a stock means you own a part of a company, giving you a claim to its profits and assets. On the other hand, a futures contract is just a legal agreement to buy or sell an asset at a set price on a future date without giving you ownership of the asset.
  
• Leverage: Stock trading typically requires you to pay the full price of the shares upfront, while futures trading allows you to control a larger position with less capital due to higher leverage. While this can increase your profits, it can also amplify your losses.
  
• Risk Profile: Futures trading is generally riskier than stock investing because of the higher position size due to leverage and traded in lots. While in stocks you can buy a single unit according to your risk appetite and capital.
  
• Time Horizon: You can hold your stock units until you want, but futures contracts have a specific expiration date, so you must close your position before that date or accept delivery of the underlying asset.
  
• Income Generation: Stocks are based on businesses, and some companies provide dividends from the generated profit, which can be a source of regular income through stocks. However, futures contracts are just trading instruments in the market and can mainly offer profit opportunities through price changes.

Educational Resources and Tools

Future contracts have been used for centuries, and there are many materials available for every kind of futures trading. Legendary traders and investors have also authored various articles and books that can be helpful for learning. Some of the books are Futures 101: An Introduction to Commodity Trading by Richard E. Waldron, A Complete Guide to the Futures Market by JD Schwager, etc.

If you want structured learning, you can choose online courses available; there are many good courses available that can give you basic knowledge of futures trading. However, trading in the real market will give you the expertise and experience.

You can also use trading simulators; many brokers provide demo accounts, so before putting in real money, you can use the virtual money for trading and backtest your idea.

Additional Tips

• Start Small: Begin with a small account size to minimize potential losses during the learning curve. This way, you won’t lose a big amount and will also gain experience in real-time trading.
  
• Continuous Learning: The futures market is dynamic, and it is crucial to stay updated with market trends and new strategies. To be updated with the trend and price action behavior, continuous learning is important.
  
• Risk Management: As a trader, your first priority should be risk management and saving your capital. To protect your capital, prioritize risk management using stop-loss orders and position sizing.
  
• Paper Trading: Peper trading may not be the best tool to learn, but to backtest your ideas it can be the perfect tool. Practice trading with simulated funds before risking real money to develop your trading skills.
  
• Diversification: Learning and investing in just a single asset can be risly. Considered diversifying your futures portfolio across different asset classes to manage risk.

Braden Chase

Braden Chase is an investor, trading specialist, and former research specialist for Forex.com who helps aspiring investors develop the confidence and habits they need to make an income from the market. Braden has served as a registered commodity futures representative for domestic and internationally-regulated brokerages and has also spoken & moderated numerous forex and finance industry panels across the globe.

Read more about Braden Chase