Futures trading is the trading of financial instruments as contracts via a futures exchange. This is often through the Chicago Mercantile Exchange (CME). It is a contractual agreement between a buyer and seller that an asset will be exchanged at a specific price and date in the future.
The buyer accepts the the obligation to purchase the underlying asset once the futures contract expires, while the seller pledges to produce the asset on its expiration. The majority of these contracts aren’t followed through. Instead, the holder tends to close their position before the expiration date and either pay or receive the difference between the current spot price of the asset and the price stipulated in the contract. Futures trading can be used for any financial market, although the most common assets to trade through futures contracts belong within the commodities, indices and forex markets.
What is a futures contract?
Futures are derivative financial contracts, meaning that they are representative of the physical asset’s price. When trading futures contracts through CFDs, you are betting on the price movements in the market without taking any physical ownership of the underlying asset. It is worth noting that futures contracts are traded using leverage, where traders are only required to deposit a small percentage of the full trade value in order to obtain greater exposure to the asset. Therefore, this increases the chances of amplified profits as well as losses.
A futures contract can be used by two types of traders: speculators and hedgers. A trader may wish to speculate on the fluctuating value of a particular asset, whereas others may decide to hedge or guarantee the future price of an asset in order to offset financial risk.
Types of future contract
Commodity futures
Commodity futures are agreements to buy or sell a pre-determined amount of a particular commodity at a specified price and date. For commodity futures contracts, the expiration month is included in the name of the contract.
The three main areas of commodities are agricultural (wheat, sugar, corn, coffee), energy (crude oil, gasoline, natural gas) and metals (gold, silver). Commodity prices are extremely volatile and can be affected by the wider geopolitical atmosphere, as well as the weather, which correlates with supply and demand. For example, if a country such as the US, which produces a vast amount of soybeans, experiences a terrible drought, then they’ll need to source those soybeans from somewhere else, such as Brazil, likely at a much higher price. Learn more about gold trading and how to trade crude oil futures, which are two of the most popular commodities on our platform.
Indices futures
Indices futures contracts are for speculating on the price movements of various stock indices, such as the Dow Jones 30 or S&P 500, which are two of the most prestigious indices in the world. Similar to commodities futures, traders can choose whether to speculate on price movements or hedge with multiple positions as an attempt to reduce risk.
Indices futures are also available as ‘E-minis’, which are based on equities. E-minis are electronically traded futures contracts that represent a small percentage of the value of standard futures contracts. The expiration of indices futures contracts doesn’t require the delivery of a physical asset, unlike the expiration of commodities futures. Instead, it is settled with cash. The amount of cash is dependent on the difference between the entry and exit prices of the contract.
Futures contract example
A farmer could trade a futures contract in order to sell 10,000 bushels of wheat to a bread manufacturer, with an agreement to sell it for $3 per bushel, in the month of September. This means that the farmer has protected the price of their crops and the bread manufacturer has control of their quarterly budget.
If the price of wheat were to decrease to $2, the buyer is contractually obligated to buy the wheat in September at $3 due to the contractual agreement.
However, should the price of wheat increase to $4 per bushel, the farmer would experience a loss, unless they decide to close their position early and cancel the order.
How to hedge futures
There is a way that commodity suppliers can attempt to protect themselves from significant losses from adverse conditions, known as hedging. This risk-management tactic is frequently used by producers of the traded commodity, as it attempts to neutralise the risk involved. If the company’s intent is to make a purchase in the future, then they could go long, and vice versa, they could go short if they intend on selling the asset. By having these prices agreed upon, it can help to reduce any uncertainty about the price of said asset in the future.
For example, forex traders hedge currency by using forward currency contracts and cross currency swaps, which are designed to hedge the risk of interest rates on a particular currency pair. These contracts are all agreed to be exchanged at a specified date and price.
Hedging with futures or forwards is particularly effective for institutional investors, who trade large volumes of a financial asset at a time.
What is the difference between futures and forwards?
Forward contracts are another type of contractual agreement where a buyer and seller agree on a specific price and date to exchange an asset. Whereas futures are traded on an exchange, forward contracts are regarded as over-the-counter (OTC) products and therefore, they can often be customised at a certain point throughout the contract. Futures contracts are standardised, which means that their terms and conditions are non-negotiable once set at the beginning.
Furthermore, the daily settlement in futures contracts differs from that of forwards trading. As implied, futures prices are settled on a daily basis until the expiration date of the contract, whereas forward cash settlement only occurs at the very end of the contract. However, it is possible with both methods to close the position early.
The value of futures contracts is also reflected in the fact that futures trading involves a clearinghouse. This guarantees that the performance of each transaction will go ahead and this is not an option in forwards trading, meaning that defaults are more likely and there is a higher credit risk.
There are advantages and disadvantages for each type of contract. On the one hand, hedgers usually prefer to trade forwards in order to avoid asset volatility, as speculating on the price of a commodity in the future, for example, can be a difficult task. Financial markets are constantly fluctuating and whereas forwards prices are set more firmly at the beginning of an agreement, futures prices are more flexible.
On the other hand, experienced traders may welcome the opportunity to trade on volatility, as this can increase the income profits if successful. However, one wrong move in a volatile market can wipe out your entire capital, as trading futures with leverage comes with many risks. Futures contracts often come with a higher leverage ratio, meaning that even a small drop in price action could lead to magnified losses.
Futures vs options
An option contract states the trader has the right but no obligation – hence the ‘option’ – to buy, or sell, the underlying asset at a specific price and at any time, just as long as the contract is in effect. In order to have this flexibility with options trading, a premium is paid in advance, which is a small percentage of the full amount. If the trader subsequently decides not to complete the trade, their only capital loss will be the premium.
Options are seen as a less risky alternative to futures contracts, partially due to having increased flexibility and also a reduced level of volatility that traders typically experience. A benefit of buying options over futures is that traders cannot encounter further losses apart from their initial investment, however selling options can make your losses potentially infinite. Forex options are particularly popular among investors, due to the volatility of the currency market.
How to trade futures
You can access forward contracts by registering for a CFD account. You can practise your futures trading strategy with virtual funds by signing up for a demo account. Futures contracts are leveraged products and are traded on margin, so only a small percentage of the overall trade is needed to enter the position. This means that that while profits may be magnified, losses are also magnified if the markets move in an unfavourable direction.
Due to the volatility of trading futures contracts, holding positions overnight leaves traders vulnerable to price changes. Therefore, it is very common for traders to implement a day trading strategy, which sees investors open and close multiple positions before the end of the day in order to take advantage of small price fluctuations and hopefully make a profit. However, the right strategy depends on the asset and market you are trading in, your personality type and level of experience. Read a more comprehensive guide to trading strategies.
Futures trading platform
Our online trading platform, Next Generation, allows you to trade forward contracts, which are an underlying form of futures, on a wide range of financial markets and assets. View our Product Library on the platform after registering for an account to browse a full list of products that we offer.
Disadvantages of trading futures
While futures contracts give traders the advantages of hedging risk, access to highly liquid markets, and the stability of a contract, there are still some disavantages of futures. For example, a trader can predict, but does not fully know, which way the markets will move before opening a futures contract. This means that price fluctuations aren’t taken into account and this will have an effect on the end price of the agreement.
Major economic indicators, such as earnings reports and economic announcements, along with fundamental factors such as natural disasters and climate changes, can lead to a jump or fall in an asset’s price. Many futures traders tend to close out the contract early, as a response to these fluctuations, in order to avoid as much capital loss as possible. As they cannot control future events, it is always a risk taking out a futures contract in volatile markets; this is why many prefer trading forwards.