A beginner's guide to trading futures contracts

Table of Contents: Masthead Sticky

• Futures contracts allow traders to speculate on the direction of price movements on asset classes such as livestock, oil, and soybeans.
• Investing in futures can provide an additional layer of diversification to a portfolio.
• Futures are more complex and carry more risks than trading stocks or ETFs because of low margin requirements and volatility.

Futures are contracts in which the buyer agrees to buy a commodity or financial instrument at a specified date and quantity at a later point in time, and the seller agrees to sell or deliver the asset as specified in the contract. These contracts were initially created to help businesses navigate unexpected costs.

For example, profits in the airline industry can be heavily dependent on the price of fuel. 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. Futures contracts can be settled in cash or with physical goods. For traders, the settlement is in cash, while some businesses may opt for physical delivery.

A futures contract can derive its value from various asset types. The most common types are commodities like wheat, corn, and crude oil. Precious metals like gold and silver, currencies, US Treasuries and stock indexes like the S&P 500.

But to trade futures, you'll want to understand the risks and investment strategies before moving forward. Here are four key areas that you'll want to get familiar with.

Note: Futures are known as derivatives. Derivatives are contracts that obtain their value from an underlying asset, index, or security.

Step 1: Understand how futures work — and the risks

Futures work differently from more mainstream investing options like stocks. Other than speculation, some investors prefer futures trading because it can offer a few benefits that are not available with stocks. For example, futures contracts trade at different hours than the stock market. Instead of 9:30 a.m. to 4 p.m. ET, the futures market is open nearly 24 hours a day, six days a week.

Another benefit to futures trading are the short-selling requirements and tax benefits. Short selling is the process of selling assets that you've borrowed with the intent on buying it back later for less money. For stocks, short selling has a higher margin requirement but futures contracts have the same margin requirement on long and short positions making it a bit more conducive for traders who are looking for this high-risk, high-reward tactic.

As for taxes, some futures trades may qualify for preferential tax rates. "Typically, gains from short-term stock trades are taxed as ordinary income. However, gains from futures contracts are taxed at a 60/40 rate which is 60% long-term and 40% short-term. Currently long-term capital gains tax rates range from 0-20% depending on your federal income tax bracket," says Moswen James, an enrolled agent at Get Help Tax.

Futures can also help an investor diversify and participate more directly in certain asset classes. For example, the stock price for a company like Exxon Mobile (XOM) will at-times be dependent upon the price of crude oil because of the nature of the company — and other factors like management and competitors. A futures contract on the other hand can be based directly on the price of crude oil without the added risk factors that a company may bring. That does not mean however that futures contracts are less risky, they are still highly complex financial instruments.

One of the largest risk factors with futures is related to the margin requirements and price sensitivity. "Futures contracts are inherently very leveraged because the underlying valuation is very sensitive to the amount of funds invested as margin or collateral," says Chester Spatt, professor of finance at Carnegie Mellon University's Tepper School of Business.

Margin is the practice of borrowing money from your brokerage to invest. Current margin requirements for futures contracts are between 3% and 12%. This means an investor could spend $5,000 of their own money to control a $100,000 position, which represents only 5%. If this trade goes in the favor of the investor, there would be a significant windfall. But a negative move could result in serious losses. Before using debt to enter a trade it is wise to carefully consider your risk tolerance.

Step 2: Choose a futures contract type and market to trade in

There are different types of futures contracts to choose from. Because each market can be so distinct from each other, a futures trader typically focuses on one or two areas, similar to how a chef may specialize in baking or desserts. This allows the trader to have a deeper understanding of that market and may help inform their trading decisions. Below are the most common categories.

• Precious metals: Gold and silver are the most common metals in this category. Investors who choose these types of futures contracts are generally looking to hedge against inflation or financial uncertainty but precious metals can also be used for more practical applications like platinum for semiconductor chips.
• Stock index: These contracts derive their value from a stock index like the S&P 500, Nasdaq, or Dow Jones. Investors try to use these types of futures to profit from anticipated movements or announcements from the Federal Reserve.
• Energy: Futures contracts that are based on energy would include oil and natural gas. These contracts can also serve as a benchmark for oil prices worldwide.
• Agriculture: Agriculture contracts in this category are usually based on things like soybeans, corn and wheat. These contracts are a bit more unique due to the fact that weather patterns and seasonality play a much bigger role in impacting prices and risk.
• US Treasury/interest rates: Futures contracts based on interest rates and Treasury bonds play a significant role in international financial markets. Investors in this category closely watch the moves of the Federal Reserve.
• Livestock: Traders can even speculate on the prices of livestock like cattle and hogs. Price movements here are subject to consumer tastes and supply and demand pressure in addition to standard risks associated with futures.

Note: Each type of futures contract is denominated in different values. For example, futures contracts for gold are denominated in 100 troy ounces but wheat contracts are 5,000 bushels.

Step 3: Choose your investing strategy

There are several investing strategies to choose from, typically a trader will become familiar with one or two contract types and specialize in a particular strategy based on their goals, risk tolerance, and comfort level. Common futures trading strategies include going long or short in a position and calendar spreads which could be bullish or bearish.

• Going long: This means that you are buying the contract and you're expecting the underlying asset to rise. The obvious risks with this strategy occur if the underlying asset drops in value.
• Going short: This strategy involves selling the contract in anticipation that the underlying asset will fall in value. This strategy however is risky because losses can be unlimited should the underlying asset rise in value since there is no true limit to how high prices can rise.
• Calendar spreads: A calendar spread is a strategy in which the trader takes both a long and short position on the same asset but with two separate expirations. The profit is generated by the spread which is the profit between the contract that was sold and the contract that was purchased. In a bull calendar spread, the trader will go long on the shorter expiration date and go short on the contract with the longer expiration. In a bear calendar spread, the positions are flipped and the trader will sell the shorter expiration contract and buy the longer one.

Step 4: Place your futures trade and manage it

A best practice for any trade is to understand the risks and price targets prior to entry. Because of the increased risks of trading futures, contracts should be carefully monitored. This is where the different order types to buy and sell may come into play and help manage the trade. A limit order offers control over the entry and exit prices. If you know the levels in which to enter and exit a trade these limit orders, as well as a stop loss can help traders execute their strategies more efficiently.

The financial takeaway

Futures trading is not suitable for every investor due to its complexity and risk. "Futures contracts have tremendous price sensitivity compared to the amount that needs to be deposited as margin or collateral. If the investor does not want to close his position after an adverse price move he should have substantial reserves available," adds Spatt.

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