While this may sound simple enough, futures trading can quickly become incredibly complex. This post will break down all the various aspects of futures trading, including what futures are, how they’re used, how they differ from other financial products, and their advantages and disadvantages. To avoid taking physical delivery of the underlying asset, you will likely need to close your position before expiration. Some brokers have mechanisms in place to do this automatically if you want to hold your position until it expires. Particular exchanges also only allow the trading of futures to institutional and professional traders.

Institutional investors include professional asset managers, pension funds, insurance companies, mutual funds, and endowments. They invest large sums of money in financial instruments, including futures contracts, on behalf of their stakeholders or beneficiaries. In the futures market, institutional investors may engage in hedging to protect their portfolios from adverse market moves or speculate on future price directions to enhance returns. Given the large volume of assets under management, institutional investors can significantly affect market prices through their trading activities.

Trading On Margin

In most cases, these companies need large amounts of specific commodities in their production or manufacturing process to make their products or to operate. Futures contracts oblige both parties who have entered the agreement to buy or sell the underlying asset. Therefore, all futures contracts for oil will come in denominations of 1,000. For example, you may enter into a futures contract for 5,000 barrels of oil or 27,000 barrels of oil, but you can’t enter into a futures contract for 1,270 barrels of oil. Oil has a tick size of one cent per barrel, which comes to $10 per contract.

A major benefit of futures is your ability to leverage your investment. By only needing to deposit a fraction of the contract’s total value (known as the margin) with your broker, you can significantly amplify your returns. This leverage allows for strong gains from relatively small price movements in the underlying asset. For example, suppose you think the S&P 500 index, which represents the stock price performance of 500 large companies listed on stock exchanges in the U.S., will rise in the next six months. You decide to buy a futures contract on the S&P 500 index, thus agreeing to purchase shares in the index at a set price at a future date, say, six months from now. If the index goes up, the value of the futures contract will increase, and you can sell the contract at a profit before the expiration date.

1. However, when trading futures, you can gain direct market exposure to specific indices or commodities.
2. Since futures trading involves some unique terminology, you’ll need to learn some of the key terms if you’re interested in futures trading.
3. That means each contract with the same underlying asset has the same contract size.
4. While much has changed as forwards have become standardized as futures contracts and exchanges offer ever-more-sophisticated products, the basics remain the same.
5. 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.
6. 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.

The price of oil futures per contract will therefore increase or decrease by $10 increments. To gain access to futures markets, though, they may ask more in-depth questions than when you opened a standard stock brokerage account. Futures contracts can be bought with very high leverage if the broker deems it appropriate. Futures trading is a way to speculate on or hedge against the future value of all kinds of assets, including stocks, bonds, and commodities.

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. 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.

Forward contracts—the precursors to futures—have been used for millennia by farmers worried that crops might drop in price by the time they are ready to harvest. Thus, they might use futures to lock in a specific price for selling their wheat. By doing so, they reduce their risk and guarantee they will receive a set price. If the price of wheat goes down, the farmer would have a gain on the hedge to offset losses from selling the corn at the market.

Hedging with futures

In some cases, however, futures contracts require physical delivery. In this scenario, the investor holding the contract until expiration would take delivery of the underlying asset. Investors risk losing more than the initial margin amount because of the leverage used in futures. If you’re using futures to hedge against unfavorable changes in prices, you could miss out if the prices go up and the hedge proved unnecessary. Futures contracts bind the buyer to purchasing and the other party to selling a stock or shares in an index at a previously fixed date and price.

As an investment tool, futures contracts offer the advantage of price speculation and risk mitigation against potential market downturns. Take 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. When the underlying assets are equities or indexes, the difference between the prices would be cash-settled in the investor’s brokerage account, and no physical product would change hands.

What are futures?

For these reasons, new investors need to put in a lot of time and effort to find out how these securities work before they start trading. Futures contracts specify dates when the agreement expires and when physical delivery of the underlying asset is due. But in practice, the vast majority of traders have no intention of taking possession of the asset in question. This graphic shows key details for the Henry Hub natural gas futures contract that’s traded on NYMEX.

Managed Futures & Risk-Adjusted Returns

With a current oil price of $70 per barrel, and the contract representing 1,000 barrels of oil, the total value of the contract is $70,000. One massive benefit of futures trading is that high levels of leverage are available. In fact, the use of borrowed cash is extremely common in the buying and selling of these contracts. They provide individuals with the right – but importantly not the obligation – to purchase said asset within a certain timescale.

Futures trading involves buying or selling futures contracts (generally referred to as futures). A futures contract is an agreement to buy or sell an underlying https://www.dowjonesrisk.com/ asset at a specific price in the future. The buyer of the contract must purchase the underlying asset upon the expiration of the futures contract.

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