The Fundamentals of Futures Trading

Trade12 - What is Futures Trading

What is futures trading?

Futures trading is the process of buying and selling of futures contracts on an exchange. A futures contract is a legal agreement to buy or sell an asset at a predetermined price and time in the future. A futures contract is a derivative product, meaning, the contract’s value depends on the underlying asset. The asset involved is usually a commodity or a financial instrument.

The predetermined price of the asset is called “forward price”, while the specified date in the future when the delivery and payment will occur is called “delivery date”.

Futures trading is usually done on the trading floor of a futures exchange. The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. The pricing can be based on an open cry system, or bids and offers that are matched electronically.

Originally, futures trading was designed to allow farmers hedge against the changing prices of commodities. Since then, the futures market has expanded from livestock and grains to a wide variety of assets such as metals, energy, bonds, and stocks.

Market participants

A futures contract is an agreement between two parties: a short position and a long position. The party who agrees to deliver the commodity is the one with the short position. They trade futures to try securing as high a price as possible in exchange of the commodity they are selling. The party who agrees to receive the commodity is the one with the long position. They take their chances in futures trading to try to secure a commodity as low a price as possible. Both parties are hedgers who aim to minimize the risk of price changes.

Another participant in futures trading is the speculator. Speculators do not aim to minimize risk; rather, they want to benefit from the risky nature of the futures market. Their objective is to make profit from the price change that hedgers are trying to avoid. For example: a spectator would buy a low priced contract from a hedger who is selling it, thinking that the value of the commodity will decline, while they, on the other hand, anticipate the commodity to sell high at a later time. Spectators don’t seek to own the commodities, but rather, they seek to make profits by offsetting the rising and declining prices through the buying and selling of contracts.

Trade12 - Characteristics of Futures Trading

Characteristics of futures trading

  • The contract itself does not have a value; instead, its price is dependent on the underlying asset it represents.
  • A futures contract has a set expiration date, after which the contract would be deemed null if it is not used. That is why knowing the right timing is important in trading futures.
  • An investor does not need to pay for the entire contract at the time the trade is initiated. Instead, the investor makes an upfront deposit to initiate the position.

Read more about the basics of online trading.

Bottom line

Entering a futures contract is a great and effective way to hedge other investment positions. However, it can also be used for speculation. Like any other types of investments, knowledge and research are a must before coming up with a decision, especially since futures trading focuses more on what would happen in the future. Another popular practice in trading futures is the use of leverage which can largely increase the potential rewards, but also be wary that it can expose the investor to outsized risks at the same time.

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