These contracts are based on the future value of an individual company’s shares or a stock market index like the S&P 500, Dow Jones Industrial Average, or Nasdaq. Futures trading on exchanges like the Chicago Mercantile Exchange can include underlying «assets» like physical commodities, bonds, or weather events. When you hear someone use the word «futures» in the finance world, they typically mean futures contracts. A futures contract provides terms for the delivery, or cash settlement, of a specified asset, such as stocks, raw materials, or products, at a specified date in the future. The value of the contract is derived from the value of the underlying asset, making futures a form of derivatives.
What Happens If Investors Hold a Futures Contract Until Expiration?
In this scenario, the investor holding the contract until expiration would take delivery of the underlying asset. The goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Suppose a mutual fund manager oversees a portfolio valued at $100 million that tracks the S&P 500. Concerned about potential short-term market volatility, the fund manager hedges the portfolio against a possible market downturn using S&P 500 futures contracts. Futures are traded on centralized exchanges like the Chicago Mercantile Exchange (CME), which lists what’s available and sets the specs for the products and contracts. By establishing terms, reviewing brokers, partnering with clearing firms, and setting margin requirements, futures exchanges make trading orderly while mitigating the risk of default.
Futures also have expiration dates, so you need to be careful to roll over or close out positions so not to be stuck with physical delivery of unwanted commodities. To start trading futures, you will need to find a brokerage that offers access to these markets and then get approval. Before trading futures, investors need to know several key elements about futures contracts to help determine position size and manage risk. We’ll use the popular E-mini S&P 500 futures contract offered by the Chicago Mercantile Exchange (CME) as an example. When considering futures trading, you must first familiarize yourself with all its processes, including transaction fees, leverage, and obligations. It is also essential to go with a trusted broker and get acquainted with various underlying assets of futures contracts.
In fact, they came about in the mid-19th century, allowing grain farmers to sell their wheat for forward delivery. Since then, they’ve evolved to include different securities and financial instruments, along with other commodities. Futures contracts offer the possibility to manage risk by anticipating upcoming events that can change market prices. The brokers only ask for part of the initial investment, a fraction of the contract’s total value, usually 3% – 10%, called the initial margin. The trading provider or broker would loan the rest to complete the total contract value. The CFTC, an independent federal agency, is the U.S.’s primary regulator for futures trading.
Individual traders or speculators commonly use futures contracts to earn a profit, or corporations or hedgers use them to hedge against inflation. Whereas individual traders don’t want to own the physical commodity, institutional investors aim to avoid price increases of raw materials they need for production. As an investment tool, futures contracts offer the advantage of price speculation and risk mitigation against potential market downturns. Taking a contrary position when hedging could lead to additional losses if market predictions are off. Also, the daily settlement of futures prices introduces volatility, with the investment’s value changing significantly from one trading session to the next. The CFTC sets rules for how contracts are traded, including requirements for margin deposits and limits on excessive speculation that would artificially distort prices.
Pros and Cons of Futures Trading
You should also review the platform’s fees and commissions and ensure they are competitive. Futures trading is leveraged, allowing investors to trade more significant amounts of money than their original investment, which means they need less equity to enter the trade. Other benefits include exposure to actual prices, tax benefits, and lower transaction costs. Corporations commonly use this tactic to lock in current prices of commodities they need in production to avoid price hikes or by individual investors to profit from price swings. If one wheat futures contract includes 5,000 bushels, and it sells at $12,50 per bushel, it is worth $62,000 of wheat, meaning that you would need less than 5% to trade it.
- Comex gold futures and crude oil futures are some examples of futures contracts.
- As a contract nears expiration, traders who want to maintain a position typically roll over to the next available contract month.
- To protect against a sudden surge in prices, an airline company can use a futures contract to lock in current prices, thus nullifying the impact of increasing fuel prices.
- This higher leverage allows investors to gain higher profits by having less equity.
- The opposite would be a long hedge strategy, which is something that an investor can use if they think that an asset will rise in value over time.
Now that we’ve explored the basics, let’s put everything all together in a trading example using the E-mini S&P 500 futures. Say the S&P 500 index recently broke out to a new all-time high, and we want to fade the move, hoping to book profits on a retracement to the initial breakout area around $4,720. Our money management rules stipulate that we risk no more than 1% of our futures trading account on any one trade and our broker requires a margin of $12,000. Whereas with other investing strategies, margin requirements for long and short positions differ, with futures contracts, the margin is the same for both without additional requirements.
How Futures Contracts Work
While you might have to pay an expense ratio on the fund, it’ll save you from having to manage a futures position or qualify for a futures trading account. Usually, the futures exchanges’ initial margin amount is around 3% – 10% of the underlying contract value. It is much lower than an equity position where the margin account required is 50% or more of its total value. The maintenance margin for that same contract is $1,400, which is set top free forex charting software for 2021 by the broker and is a required minimum on your account at all times. If the money on the account drops below $1,400, the trader must make an extra payment to return it to the initial margin. For example, the initial margin of one wheat futures contract is $2,500, which is a required minimum to open a trade on a futures exchange.
This article explores some of the benefits and challenges you may encounter while trading your futures. All strategies have ups and downs, but https://forexanalytics.info/ you should decide which one you want to go with and define it for your futures trading. In terms of the trading strategies of speculators, it is normal for them to choose one to two main sectors they specialize in and have a thorough understanding of those markets. Yet futures ultimately offer defined, manageable risks if utilized responsibly. By understanding the risk-reward relationship in futures, you can weigh how to trade in them more appropriately. Investors who are interested in learning more about these possibilities can benefit from reading this article, which can help educate them on futures trading for beginners.
For example, it isn’t easy to know whether commodities’ prices, such as corn, go up or down without in-depth market knowledge. It takes an edge and understanding of markets’ fundamentals and economic trends, sentiment, and approach via technical analysis. Futures trading usually involves leverage and the broker requires an initial margin, a small part of the contract value. The amount depends on the contract size, the creditworthiness of the investor, and the broker’s terms and conditions.
This is in contrast to options trading, which gives the trader the right but not the obligation to settle their contracts. This higher leverage allows investors to gain higher profits by having less equity. However, it can equally put you at risk of losing more money than initially invested. Even though futures trading comes with higher risks due to leverage and more complicated investing and trading processes, it has several upsides.
What is futures trading?
If you understand how futures markets work and how futures could play a role in your portfolio, they can provide some welcome diversification to your holdings. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation.
Stock futures have specific expiration dates and are organized by month. For example, futures for a major index like the S&P 500 might have contracts expiring in March, June, September, and December. The contract with the nearest expiration date is known as the «front-month» contract, which often has the most trading activity. As a contract nears expiration, traders who want to maintain a position typically roll over to the next available contract month.