Futures Trading: The Essentials for Getting Started Now

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Futures were originally used by a few farmers anxious to sell their crops in advance. Today, futures are the world’s second most traded financial derivative, with no less than 29 billion contracts traded in 2022).

These financial instruments were initially limited to agricultural commodities. Now they are accessible with just a few clicks from top brokers. Their availability via stock market indices opens up a broad spectrum of assets ranging from oil to orange juice.

What are the advantages and disadvantages of futures trading? How do you learn to trade futures? How do you get started in futures trading? 

Here are our answers!

WARNING

Trading exposes you to the risk of losing more than your initial investment and incurring financial liability. Trading is suitable only for well-informed, sophisticated clients able to understand how the products being traded work and having the financial ability to bear the aforementioned risk.

Transactions involving foreign exchange instruments (FOREX) and contracts for difference (CFD) are highly speculative and extremely complex. As such, they are subject to a high level of risk due to leverage. Please keep in mind that CDF trading is banned in the US.

Information published on the NewTrading.io website is for educational purposes only and should not be construed as offering investment advice or as an enticement to trade financial instruments.

What is Futures Trading?

Futures trading consists of trading standardized futures contracts to profit from their price variations, whether rising or falling.

Technically speaking, a futures contract is a financial derivative whose value depends on the price of an underlying asset (share, currency, commodity, etc.). 

The buyer of a futures contract agrees to purchase the underlying asset at a future date and at a predetermined price. Accordingly, the buyer is betting that the price of the asset will rise. They are taking a “buy” or “long” position.

Conversely, the seller of a futures contract agrees to sell the underlying asset at a future date and at a predetermined price. Accordingly, the seller is betting that the price of the asset will fall. They are taking a “sell” or “short” position.

The price of a futures contract quoted on the market hinges on shifts in the balance of power between supply and demand in the order book.

Noteworthy

Open interest is the total number of outstanding futures either bought or sold. They are open because they have not yet been closed by an opposite transaction. All things being equal, the greater the open interest, the greater the market liquidity!

How Does Futures Trading Work?

Because the futures market is an organized market (unlike the forwards market), the trader’s counterparty is not another trader but a clearing house.

Tasked with acting as intermediaries between buyers and sellers of futures contracts, clearing houses eliminate counterparty risk, that is, the risk that one of the parties might fail to honor their commitment under the contract to buy or sell the asset on the stipulated date and at the predetermined price.

Several financial centers around the world issue standardized futures contracts, including the Chicago Mercantile Exchange (CME Group), the Intercontinental Exchange (ICE), Eurex, the London Metal Exchange (LME), the Tokyo Commodity Exchange (TOCOM), and the Shanghai Futures Exchange (SHFE), to name but a few.

These exchanges have established a set of attributes for their futures:

  • Underlying asset
    The asset that will be bought or sold at maturity.
  • Contract size
    The number of underlying assets to be bought or sold at maturity. 
  • Expiration date
    The date the contract will be settled.
  • No quotation
    The smallest possible price movement on the market (e.g., $0.01).
  • Contract price
    The agreed-upon price for the purchase or sale of the underlying asset.
  • Fluctuation limits
    Maximum daily amplitude allowed on the upside (limit up) and on the downside (limit down) to avoid excessive price variations. When the maximum amplitude is reached, the market is suspended until the next trading session opens.
  • Margin requirements
    The funds required to cover the risk of loss on the contract. To open a position, you must deposit this minimum amount in your trading account.
  • Settlement terms
    Physical settlement (delivery) of the underlying asset or financial settlement (payment of the difference between the contract price and the market price of the expiring asset).
Noteworthy

Financial centers share the characteristics of all futures contracts on their respective websites. Here is a sample E-mini S&P 500 contract.

Futures trading lets you use leverage and trade on margin. 

The available margin represents the funds in your trading account available to open new positions. It corresponds to your total funds minus the locked-in margin (the margin used to cover the risk of your open positions).

To open a new position in a futures contract, your broker will require your available margin to be greater than or equal to the initial margin required.

Thereafter, to maintain this position, you must guarantee that you will keep a certain amount in your account despite any potential unrealized capital losses This is your maintenance margin

If you fail to do so, you will receive a margin call, to which you can respond by adding new funds to replenish your margin or by liquidating part of your positions to reduce your margin requirement.

If you fail to meet your margin call on time, your broker will automatically close your position!

Noteworthy

The nominal value of the futures contract (or notional value) corresponds to the contract point value multiplied by the value of the underlying asset. It is generally used as a basis for calculating margin levels.

Understanding the Relationship Between Spot and Futures Prices

Buying an asset today is not the same as buying it tomorrow. Paying for an asset upfront means you are tying up money and in some cases incurring significant storage costs.

Try hosting the forty or so cattle from a Chicago Mercantile Exchange (CME) futures contract in your living room, and you’ll quickly grasp the full extent of the problem! 

In such a situation, it is best that you not become the owner of the livestock until the last minute to avoid having to deal with these costly roommates for as long as possible.

On the other hand, if the futures contract is not about a herd of frantic cattle but about a stock market index comprised of companies about to pay generous dividends, it is better to have this basket of stock in your portfolio today, so you can start getting the payouts!

On the market, the difference between the spot price and the futures price is referred to as forward points. 

When this difference is positive, that is, when the spot price is higher than the futures price, we are in a backwardation situation.

On the other hand, when this difference is negative, that is, when the spot price is lower than the future price, we are in a contango situation.

Example of a Futures Trade

Suppose you want to buy a futures contract on the S&P 500 index. 

The US stock market index currently stands at 3990 points. On the other hand, the E-Mini S&P 500 contract issued by CME Group, expiring in June, is trading at 4,000 points.

The difference between the spot and the forward prices is positive, so we’re in a contango situation.

Because the point value is set at $50 by the contract, the E-Mini S&P 500 contract has a value of 4000 points x $50, or $200,000.

However, thanks to leverage, you do not need to pay the full amount to acquire this contract. Let’s assume that the initial margin required by your broker is 5% of the value of the contract. You’ll only need 5% of $200,000, that is, $10,000.

Every time the futures contract rises by one point, you earn $50. On the other hand, every time it drops a point, you lose $50.

Please note that this simplified calculation does not consider brokerage fees or other charges!

Futures Trading: Three Possible Objectives

From the international company worried about reducing its exposure to currency risk to the independent trader ready to challenge the market in the hope of making money, a wide range of players come together on the futures market.

This variety of contributors seeks to achieve the following:

  • Hedging transactions
    Hedging strategies on futures involve opening financial positions whose attributes (direction, size, maturity, and so on) offset the risks of an existing position in order to reduce or even neutralize overall risk.
  • Arbitrage transactions
    Futures arbitrage involves simultaneously buying and selling two futures contracts on two different markets to profit from the price difference and reap a “risk-free” capital gain.
  • Speculative transactions
    Futures speculation involves buying or selling a futures contract, thereby betting on whether the price of the derivative will rise or fall and making money in the process.

The Most Popular Futures Markets

Although there are thousands of different futures contracts, they can be grouped into a handful of major asset classes.

  • Index futures
    These are futures contracts on popular stock indices such as the S&P 500, Dow Jones Industrial Average, NASDAQ, CAC 40, Nikkei 225i, and FTSE 100.
  • Commodity futures
    These are futures contracts on agricultural products (wheat, corn, soybeans, oats, rice, sugar cane, coffee, cocoa, cotton, silk, etc.), energy products (crude oil, natural gas, gasoline, coal, electricity, etc.), metals (gold, silver, platinum, palladium, copper, aluminum, zinc, nickel, lead, etc.) or foodstuffs (orange juice, sugar, eggs, etc.).
  • Currency futures
    These are futures contracts on the FOREX market, such as futures on major currency pairs (EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD, USD/CAD, NZD/USD), minor currency pairs (EUR/GBP, EUR/AUD, GBP/JPY, CHF/JPY, AUD/CAD, NZD/JPY) and exotic currency pairs (USD/SGD, USD/HKD, USD/SEK, USD/DKK, USD/ZAR or USD/THB).
  • Crypto-currency futures
    These are futures contracts on digital currencies (Bitcoin and Ether).
  • Bond futures
    These are futures contracts on bonds and Treasury bills, depending on the geographic region targeted, such as futures on the UK Gilt, US T-bills or T-notes, or the German Bund.

Noteworthy

There also futures on individual stocks, real estate, and climate!

Futures Trading Strategies

You can trade futures using several different trading strategies, depending on your appetite for risk, knowledge of financial markets, availability, and trading goals.

Here are the most popular trading styles:

  • Scalping. Scalping seeks to make profits on minimal price changes over a very short time horizon (from a few seconds to a few minutes).
  • Day Trading. Day Trading opens and closes trading positions within minutes or hours, but always within the same trading session.
  • Swing Trading. Swing Trading holds positions for several days, or even weeks, to take advantage of medium-term market trends.
  • Position Trading. Position trading, on the other hand, seeks to capture long-term trend movements. In futures, this involves “rolling” positions from one maturity to the next, that is, buying a new future when the first matures.

Advantages of Futures Trading

  • Liquidity
    Unlike other derivatives, futures are traded on relatively liquid markets. This greater market depth makes it possible to enter and exit positions quickly and easily without significantly impacting prices.
  • Transparency
    Because futures are traded on regulated markets, their prices and trading history are readily accessible. The majority of transactions are registered and regulated by the authorities.
  • Leverage
    Futures are often traded on margin with leverage, allowing the trader to use only a fraction of their capital.
  • Flexibility
    Beyond the different financial markets available, trading futures provides traders greater flexibility, with extended sessions compared to those of stock market indices.
  • Diversification
    Futures can be used with different asset classes. Accordingly, they allow investors to diversify their investments in various markets.
  • Risk management
    Since futures offer greater diversification, you can reduce overall portfolio risk by better allocating funds between different assets.
  • Trading and execution fees
    The top futures brokers offer lower trading fees on futures than on the underlying shares themselves.
  • Low barrier to entry
    You can start trading futures by committing relatively little capital to each position, using regular, E-Mini, and Micro E-Mini futures. They are different sizes but part of the same contract. Accordingly, traders can use the contract best suited to their funds.
  • A simpler understanding of price formation
    It is easier to understand price formation of futures than price formation of other derivatives, such as options.

Disadvantages of Trading Futures

  • Contract expiration date
    Futures contracts have fixed expiration dates, which means the trader will only have two options at the expiration date: liquidate or roll it over to the next expiration date (and pay the rollover fee).
  • Futures are intended for experienced traders and investors
    Futures are complex products that must be fully understood before incorporating them into a trading strategy. Therefore, they are rarely used by novice retail traders.
  • High risk of loss
    Futures trading involves a high risk of loss, with double-edged leverage that can boost gains but exacerbate losses.

Choosing the Right Futures Broker

Choosing the right futures broker for your strategy is crucial if you want to implement it under the best possible conditions and hope to get good results. 

Consider the following:

  • Regulation
    Selecting only regulated brokers will provide better protection and help you avoid scams.
  • Trading account type
    Depending on your needs and trading frequency, it may be helpful to know which types of trading accounts are available so you can select the one that best suits your trading style.
  • Financial assets available
    Not all brokers work with every type of financial instrument or in every market. Make sure the futures broker you choose offers a broad array of assets so you can create a diversified portfolio.
  • Transaction fees and other charges
    Fees may vary considerably from one broker to another. In addition, fees and charges should align with your trading style so you can trade in a competitive environment. In addition to commissions and trading fees, you also must consider ancillary fees and charges for deposits and withdrawals, conversions, swaps, subscriptions, and so on.
  • Available Trading platforms
    Several trading software packages are available on the market, such as ProRealTime, TradingView, MetaTrader, NinjaTrader, and others offering tools for trading and technical analysis or other specific services.
  • Customer service
    Make sure that the broker will deliver excellent and professional customer service. You need to be familiar with the support team’s availability so you can contact them when need be.
  • Educational resources
    If you want to augment your trading knowledge, find out what educational materials are available from the brokers you are targeting.

Futures or CFD Trading?

Due to the higher dollar value of futures’ standard contracts, retail traders sometimes shy away from them because they want to trade with a more modest amount of capital. 

After a few years, however, independent traders tend to prefer futures trading to CFD trading for several reasons.

#1 Better protection

Because futures are traded on regulated exchanges (and not on the OTC market), they offer greater protection for the trader and significantly reduce counterparty risk. And with good reason. The risk of a CFD broker going bankrupt is far greater than that of an entire financial center failing.

In addition, futures also tend to offer higher liquidity than CFDs, especially on the most popular commodities and stock market indices, thus guaranteeing a higher quality execution and reducing the risk of slippage.

#2 A favorable spread

All things being equal, a natural spread is preferable to an artificial one. 

Futures’ natural spread allows you to move back and forth across the order book price range, either buying at the low end to sell at the high end or selling at the high end to buy back at the low end.

Accordingly, you can make a profit by exploiting the natural spread of a future, whereas this is impossible on the artificial spread of a CFD, which the broker immediately cashes in.

#3 No overnights

When a position remains open after the market closes, CFD traders are charged an overnight fee (also known as a swap fee). With futures, you can avoid paying these fees, which are incredibly costly in the long run.

Are you thinking of trading futures? 

Make sure you choose a credentialed broker to ensure an enjoyable trading experience, flawless execution, and a fair price.

author
Maxime Parra

Maxime holds two master’s degrees from the SKEMA Business School and FFBC: a Master of Management and a Master of International Financial Analysis. As founder and editor-in-chief of NewTrading.fr, he writes daily about financial trading.

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