A futures contract is a derivative contract through which a buyer and seller agree to buy or sell an asset at a future date and for a fixed price. The futures contract can be used by investors, speculators, and traders because the futures market caters to different securities. The futures securities include energy, indexes, stock, currencies, cryptocurrencies, forests, interest rates, livestock, and grains.
There is something for everybody in the futures market, which makes it a lucrative trading option. However, it is key to have the necessary information before you proceed.
Success in futures trading can mean significant profits but mistakes tend to be very costly. Here’s what you need to know to get ahead in futures trading.
How Does Futures Trading Work?
In the futures market, traders either want to protect themselves against loss due to unwanted price changes or make a profit from an increase in the price of an asset. To understand how futures trading works, here’s an example.
A trader wants to lock in stock prices to avoid an unwanted increase later. To do that, they will buy a futures contract agreeing to buy X amount of stocks at a specific price and a set time in the future. A seller will sell the futures contract to the prospective trader, and both sides have to agree on the terms of the contract before it can be valid. At the given time, the contract will be executed regardless of the current market price.
Every futures contract specifies the following:
- The unit of measurement
- The proposed method of settlement
- The currency unit of the contract
- The quantity of goods covered under the contract
By taking on the contract, both parties are obligated to fulfill their parts of the contract.
There are two ways traders can approach future contracts:
- Hedging: Hedging is a method traders use to protect themselves from the fluctuating price of an underlying asset. Through a futures contract, a hedger basically guarantees that the asset can be bought or sold at the given market price to avoid serious losses if the market takes a negative turn.
- Speculating: Speculators trade futures contracts by betting on the future price of a security. A speculator predicts if the market price is going to rise or fall and takes either a long or short position, and the trader will profit if their speculation is correct.
If a speculator believes that the current price of Bitcoin is going to increase, they would buy Bitcoin futures for a low price and set a higher price to be executed at a given time. When the speculator thinks the price of Bitcoin is going to fall, they can short-sell the asset, wait until the price decreases and purchase a futures contract for such an asset.
Speculating is a short-term strategy that requires traders to make highly educated guesses due to the high risk involved. For traders who want to engage in futures trading as a speculator, taking up futures trading books and other learning materials is important to increase your knowledge of it.
Best Tips for Trading Futures
Here’s what you can do to get started with futures trading quickly:
1. Understand the contract specifications
You will need to open an account with a futures broker if you want to start trading. Probably the most important thing you should look out for is the contract specification of your desired broker. This entails all the necessary details that will affect your trading activities and increase the risks of trading with such a broker.
When looking at the specifications, look out for these key details:
- Trading Hours: Trading hours will vary depending on the contract, but most will let you trade for the better part of 24 hours every trading day. So, take a look at different contracts and liquidity patterns during the 24-hour period before making your decision.
- Listed Contracts: Looking at the listed contracts will let you know what month or quarter the contract represents.
Each month or quarter is represented by a letter or symbol. It makes it easier to understand which contract you want to trade at any given time. For instance, if you are trading the February 2022 NASDAQ 100 futures, the resulting ticker symbol will be NDG22.
- Expiration Date: Most futures contracts have an expiration date. Sometimes, the value of the underlying asset might drop or rise significantly when the termination date draws near.
The termination date is typically on the third Friday of the contract month, but it varies from one broker to the other, so you still need to confirm and determine if it works for you.
- Minimum price fluctuation: It shows you the amount of increment the contract allows and what it is worth. This will have an impact on the profit or loss in your portfolio after every trade.
2. Start with a few contracts
Futures trading requires you to constantly be aware of what is happening in the market. Therefore to become a successful futures trader, you will need to invest a significant amount of time and energy.
If you spread yourself thin by trading too many markets, you won’t be able to give each one the attention it requires, and this can affect your trading ability. As a beginner, take it slow and start out with two futures markets you are interested in. With this, you’ll have enough time to master each market and diversify your portfolio enough to offset losses.
3. Margin and leverage
Leverage and margin are two important elements in futures trading:
Margin refers to the capital needed to buy or sell a futures contract. Margin in futures is similar to that of other assets, and there are two main types:
- Initial Margin: This is the required amount for entering into a position, whether long or short. Initial margin may also be referred to as performance bond.
- Maintenance Margin: This is the minimum account that should be in your account before you can continue holding an existing futures contract. If it goes below that level, you will be asked by the broker to fund your account or liquidate your contract if that is not possible.
When you receive a margin call from the broker, it is probably a sign that you have stayed with a losing trade for too long. Before you fund your account again, take a look at the contract and determine its profitability.
Exit the position to reduce the losses suffered and open a new one. But you can also shrink your position if you want to keep it open and reduce your margin requirement.
In futures, it is advisable to add capital well above the margin requirement as a way of increasing your contract value and gaining access to a reasonable amount of leverage if you want to use it.
Leverage is a double-edged sword in any financial market, including futures. It can increase your position size and raise your potential for profit, but if it is not handled properly, it will result in massive losses.
A futures contract offers better leverage and less capital exposure to start a transaction, but the market is more complex than others. A good risk management tip when using leverage is to only trade with the amount you are willing to risk. In addition, measure the historical volatility of the asset with a technical indicator so that you can understand the risks associated with your trades. In cases of high volatility, reduce your position size because it enables you to absorb swings better and trade with greater flexibility.
4. Have an exit strategy
Traders spend their time looking for the perfect entry-level, but it is how you exit that determines if the trade is successful.
The most common exit strategy is using stop loss orders and take profit targets to protect your trades from losses. Place a stop loss at the level of risk you are willing to take, and the trade will close automatically if it reaches that target.
Using one-triggers-other or order-sends-order allows you to place an order and stop at the same time. So when your primary order is initiated, your protective stop loss gets triggered as well. This frees you from worrying about where and when to place your stop loss and gives you more time to focus on another market if you are trading more than one market at a time.
Another exit method involves the use of the Average True Range to measure the volatility of the market. With this, traders can tell the rate of price fluctuations and set stops and limits accordingly.
The greater the ATR, the wider the stop loss. Stop loss orders do not eliminate the place of risk from futures trading, and you will still experience losses. What it does is put a check on the level of losses and manage your emotions when trading.
5. Go at a steady pace
Don’t use all your capital to purchase or sell futures contracts. After deciding which market you want to trade in, start with one or two contracts. Establish small positions first and develop your trading strategy the more you advance in the market. This gives you time to establish your competitive edge and refine it. As a new futures trader, downsize your position when you experience massive losses so that your capital won’t be wiped off completely. Once you are steadily making profits, gradually increase your position and keep improving your strategy.
Futures trading is complex, and you should always maintain a long-term perspective. Don’t let your trading actions be affected by every fluctuation, and you can lengthen the duration of your trade so that your trades won’t be thrown off.
Stick with your strategy, and always remember to cut your losses when you notice that trade is no longer profitable.