UnderstandingandTrading Futures

What areFutures?

Futures are a type of derivative contract created to streamline the buying or selling of specific commodity assets or securities, at a predetermined price and date. Known as futures contracts, these contractual instruments are actively traded on specialised futures markets like the CME Group. To trade futures contracts, you are required to use a brokerage account that has been approved for activities related to futures trading.

TradingFutures

Trading futures revolves around the buying and selling of futures contracts by individuals and institutions in the financial market. These futures contracts represent an agreement between two parties to either purchase or sell a designated amount of an underlying asset. These assets span commodities, like gold, agricultural products, and oil; financial instruments, such as currencies and stock indices; and even extend to interest rates. The execution of these agreements takes place at a pre-established price on a specified date.

The main aim of futures trading is to speculate on the anticipated price movements of the underlying asset being traded. Based on their analysis, traders can choose to take a long position (meaning they think the asset’s price will rise, so they buy) or short position (if they think the asset’s price will fall, so they sell).

Below we take you through the stages of futures trading:

  1. Choose an asset and contract: Traders use their market analysis to decide which asset they are interested in trading. Each asset comes with its respective futures contract, featuring standardised terms such as expiration date, contract size and tick size (which represents the minimum price movement).
  2. Opening a position: Traders have the option of opening a position either by purchasing a futures contract (i.e. going long), if they foresee an increase in the asset’s price, or selling (i.e. going short), if they anticipate the asset’s price will fall.
  3. Margin requirement: In contrast to outright stock purchases, engaging in futures trading necessitates the provision of a margin, representing a portion of the total value of the contract. This margin acts as a performance bond, ensuring both parties fulfill their respective obligations.
  4. Monitoring market movements: With market fluctuations, the price of the contract undergoes changes. Traders must closely observe these movements, as they directly influence the value of their positions.
  5. Exiting the position: Traders have the flexibility to exit their positions at any time before the contract expires. If the trade unfolds as expected, they can choose to close the position and secure their profits. Alternatively, if the trade takes an unfavourable turn, traders have the option of closing the position to minimise their losses.
  6. Settlement: There are two methods by which futures contracts can be settled: with cash, or with physical delivery. The former, cash settlement, is used more often, and entails settling the contract’s value in cash. This value is calculated as the difference between the contracted price and the market price when the contract expires. Physical delivery, on the other hand, entails the actual transfer of the underlying asset.
  7. Contract expiry: Futures contracts come with pre-established expiration dates. Traders have to make decisions about when to close their positions. There are three options: close the position before the expiration, extend the contract to a later date, or continue with settlement (be that physical or cash).
  8. Risk management: Effective risk management is really important, due to the inherent leverage in futures trading. Traders can employ a range of strategies to mitigate potential losses, including the use of hedging and stop-loss orders.

It’s vital that traders acknowledge that futures trading entails considerable risk, primarily because of the leverage involved. While the capacity to manage a larger position with a relatively smaller margin can result in significant profits, it also has the potential to magnify losses. This means that anyone considering futures trading should make sure they have a comprehensive understanding of the market, establish a robust trading plan, and perhaps take guidance from a more experienced or professional trader.