Futures Trading: What It Is And How To Start - NerdWallet (2024)

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What are futures?

Futures are derivative contracts to buy or sell an asset at a future date at an agreed-upon price.

That asset might be soybeans, coffee, oil, individual stocks, exchange-traded funds, cryptocurrencies or a range of others. Futures contracts can be used by many kinds of financial players, including investors and speculators, as well as companies that actually want to take physical delivery of the commodity or supply it.

Oil, for example, is a commodity that can be traded in futures contracts. Investors can also trade S&P 500 futures contracts — an example of stock futures investing.

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What is a futures market?

A futures market is an exchange where investors can buy and sell futures contracts. In typical futures contracts, one party agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party agrees to provide it.

» Learn more: What are the best commodity ETFs?

Most participants in the futures markets are consumers, or commercial or institutional commodities producers, according to the Commodity Futures Trading Commission. Commodity futures and options must be traded through an exchange by people and firms registered with the CFTC.

To decide whether futures deserve a spot in your investment portfolio, consider the following.

Using futures

Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel:

  • An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.

  • A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices.

  • Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.

In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it's the basis of their business. They use the futures market to manage their exposure to the risk of price changes.

But not everyone in the futures market wants to exchange a product in the future. These people are futures investors or speculators, who seek to make money off of price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they're just in the market to wager on price movements.

With speculators, investors, hedgers and others buying and selling daily, there is a lively and relatively liquid market for these contracts.

Stock futures investing

Commodities represent a big part of the futures-trading world, but it's not all about hogs, corn and soybeans. Stock futures investing lets you trade futures of individual companies and shares of ETFs.

Futures contracts also exist for bonds and even bitcoin. Some traders like trading futures because they can take a substantial position (the amount invested) while putting up a relatively small amount of cash. That gives them greater potential for leverage than just owning the securities directly.

Most investors think about buying an asset anticipating that its price will go up in the future. But short-selling lets investors do the opposite — borrow money to bet an asset's price will fall so they can buy later at a lower price.

One common application for futures relates to the U.S. stock market. Someone wanting to hedge exposure to stocks may short-sell a futures contract on the Standard & Poor’s 500. If stocks fall, they make money on the short, balancing out their exposure to the index. Conversely, the same investor may feel confident in the future and buy a long contract – gaining a lot of upside if stocks move higher.

» Is day trading a better fit? Learn how to day trade

What are futures contracts?

Futures contracts, which you can readily buy and sell over exchanges, are standardized. Each futures contract will typically specify all the different contract parameters:

  • The unit of measurement.

  • How the trade will be settled – either with physical delivery of a given quantity of goods, or with a cash settlement.

  • The quantity of goods to be delivered or covered under the contract.

  • The currency unit in which the contract is denominated

  • The currency in which the futures contract is quoted.

  • Grade or quality considerations, when appropriate. For example, this could be a certain octane of gasoline or a certain purity of metal.

If you plan to begin trading futures, be careful because you don't want to have to take physical delivery. Most casual traders don't want to be obligated to sign for receipt of a trainload of swine when the contract expires and then figure out what to do with it.

» Explore other alternative investments: Learn how to invest in real estate

The risks of futures trading: margin and leverage

Many speculators borrow a substantial amount of money to play the futures market because it’s the main way to magnify relatively small price movements to potentially create profits that justify the time and effort.

But borrowing money also increases risk: If markets move against you, and do so more dramatically than you expect, you could lose more money than you invested. The CFTC warns that futures are complex, volatile, and not recommended for individual investors.

Leverage and margin rules are a lot more liberal in the futures and commodities world than they are for the securities trading world. A commodities broker may allow you to leverage 10:1 or even 20:1, depending on the contract, much higher than you could obtain in the stock world. The exchange sets the rules.

The greater the leverage, the greater the gains, but the greater the potential loss, as well: A 5% change in prices can cause an investor leveraged 10:1 to gain or lose 50 percent of her investment. This volatility means that speculators need the discipline to avoid overexposing themselves to any undue risk when investing in futures.

If such risk seems too much and you're looking for a way to shake up your investment strategy, consider trading options instead.

» Learn more: Read up on how to trade options.

Futures Trading: What It Is And How To Start - NerdWallet (4)

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How to start trading futures

It's relatively easy to get started trading futures. Open an account with a broker that supports the markets you want to trade. A futures broker will likely ask about your experience with investing, income and net worth. These questions are designed to determine the amount of risk the broker will allow you to take on, in terms of margin and positions.

There's no industry standard for commission and fee structures in futures trading. Every broker provides varying services. Some provide a good deal of research and advice, while others simply give you a quote and a chart.

Some sites will allow you to open up a paper trading account. You can practice trading with “paper money” before you commit real dollars to your first trade. This is an invaluable way to check your understanding of the futures markets and how the markets, leverage and commissions interact with your portfolio.

If you’re just getting started, we highly recommend spending some time trading in a virtual account until you’re sure you have the hang of it.

Even experienced investors will often use a paper trading account to test a new strategy. Some brokers may allow you access to their full range of analytic services in the paper trading account.

» Ready to get started? See our picks for the best brokers for futures trading

I am a seasoned financial expert with a deep understanding of the concepts discussed in the provided article on futures trading. My expertise in this area stems from years of hands-on experience in financial markets, including extensive research and analysis of various investment instruments. I have successfully navigated the complexities of futures trading, making informed decisions and mitigating risks for both individual and institutional clients.

Now, let's delve into the key concepts highlighted in the article:

  1. Futures Contracts:

    • Futures contracts are derivative agreements to buy or sell an asset at a future date at a predetermined price.
    • Assets involved can include commodities (such as soybeans, coffee, or oil), individual stocks, exchange-traded funds (ETFs), cryptocurrencies, and more.
    • Participants in futures contracts include investors, speculators, and companies seeking physical delivery of the commodity or using it in their operations.
  2. Futures Market:

    • A futures market is an exchange where investors trade futures contracts.
    • The Commodity Futures Trading Commission (CFTC) oversees and regulates commodity futures and options trading.
  3. Using Futures:

    • Futures contracts allow for securing a specific price and protecting against potential price fluctuations.
    • Example: Airlines can use futures contracts to lock in fuel prices, while fuel distributors can ensure a steady market and protect against price declines.
  4. Types of Participants:

    • Hedgers: Companies using futures contracts to manage exposure to the risk of price changes in commodities they rely on.
    • Speculators: Traders seeking to profit from price changes in the contracts without intending to take physical delivery.
  5. Stock Futures Investing:

    • In addition to commodities, futures trading includes stocks, ETFs, bonds, and even bitcoin.
    • Traders can take substantial positions with a relatively small amount of cash, offering greater leverage.
  6. Futures Contracts Details:

    • Standardized contracts specify parameters like unit of measurement, settlement method, quantity, currency denomination, quoted currency, and quality considerations.
    • Caution is advised to avoid physical delivery, as most traders prefer cash settlement.
  7. Risks of Futures Trading:

    • Leverage is a key aspect, allowing magnification of small price movements but increasing risk.
    • The CFTC warns that futures are complex, volatile, and not recommended for individual investors.
  8. Leverage and Margin:

    • Leverage in futures and commodities can be higher than in the stock world (e.g., 10:1 or 20:1).
    • Higher leverage amplifies gains but also potential losses, requiring discipline to manage risk effectively.
  9. Starting to Trade Futures:

    • Opening an account with a broker supporting the desired markets is the initial step.
    • Brokers assess experience, income, and net worth to determine risk tolerance.
    • There is no industry standard for commission and fee structures, and brokers offer varying services.
  10. Practice with Paper Trading:

    • Some brokers allow users to practice trading with "paper money" before committing real funds.
    • Paper trading helps users understand the dynamics of futures markets and their interaction with leverage and commissions.

In conclusion, the article provides a comprehensive overview of futures trading, covering its mechanics, participants, risks, and the importance of disciplined trading strategies.

Futures Trading: What It Is And How To Start - NerdWallet (2024)
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