futures

What does ‘futures’ mean?

Futures are exchange-based contracts that allow two parties to agree on buying or selling a specific asset at a predetermined price on a set future date. These contracts are a type of derivative, meaning their value comes from an underlying asset. Common underlying assets include:

• commodities
• currencies
• indices

Futures are traded on regulated exchanges. As for futures markets, they operate almost 24 hours a day, five days a week.

The underlying assets for futures contracts are diverse. Hard commodities such as precious metals and natural gas are frequently traded. Soft commodities are also common. Some examples include:

• coffee
• cocoa
• sugar
• cotton
• soybeans
• wheat
• corn

Watch this video to know more about futures:

Aside from futures, there are other types of derivatives that your clients might want to look at when building their portfolios.

How does futures trading work?

Futures trading takes place on regulated exchanges. These exchanges provide a platform for buyers and sellers to meet and trade contracts. Each trade creates a new contract, and there is no limit to how many contracts can be created. This is different from stocks, where the number of shares is fixed.

The price of a futures contract is determined by supply and demand, as well as the expectations of traders. There are also different pricing models.

For instance, the Cost of Carry Model says that the futures price equals the spot price plus the cost of holding the asset until the contract expires. The Expectancy Model looks at what traders think the spot price will be at the contract’s expiration date.

Various ways of futures trading

Futures contracts can be traded in several ways. The most common is through a regulated exchange, which requires a broker and follows strict rules to reduce the risk of default. There is also over-the-counter (OTC) trading, where the terms are set by the two parties involved. However, OTC contracts are less liquid and carry more risk.

Another way to trade is through contracts for difference (CFDs). With CFDs, your clients do not own the asset. Instead, they agree to exchange the difference in price from when the position is opened to when it is closed. CFDs are popular because they allow for leveraged trading and are available through many online brokers.

Check out this video on futures trading:

Do you have clients who want to start trading stocks, futures, or other assets? Feel free to check out our beginner’s guide!

How long do futures contracts last?

Every futures contract comes with a set expiration date. This is the date when the contract must be settled, either by delivering the underlying asset or by closing out the position. The length of time a futures contract lasts depends on the specific contract and the asset involved.

Focus on the short term

Most futures traders are not looking years into the future. They are focused on price prospects over the next few months. As new information about supply and demand comes in, the price of the futures contract changes. Traders take positions based on what they think the price will be when the contract expires.

Final settlement price

When the expiration date arrives, trading for that certain contract stops, and a final settlement price is determined. Many investors will have already decided what to do with their position before this date.

Some will close out the contract to avoid taking delivery of the asset, while others might roll their position into a new contract with a later expiration date.

The standardized nature of futures contracts also means that the terms—such as quantity, quality, and delivery—are set in advance. The only thing that changes is the price. This standardization helps create a transparent and efficient market where buyers and sellers can meet.

Benefits of futures trading

Check out these advantages in trading futures contracts:

1. Leverage
   Your clients can control a large amount of the underlying asset with a relatively small upfront margin. If the leverage ratio is 500:1, they only need to deposit less than one percent of the total value of the position. This can amplify profits, but it can also increase losses. As such, it’s critical to use leverage carefully.
2. Liquidity
   Futures markets are generally known for being highly liquid, especially for major contracts. This means your clients can enter and exit positions more easily. This is useful if they want to react quickly to market changes.
3. Speculation
   Let’s use a sample scenario. If your clients believe that the price of oil will rise in the coming months, they can buy a futures contract and sell it later at a higher price. If they expect prices to fall, they can sell a contract and buy it back at a lower price.
   Either way, the goal is to profit from price movements, not to take delivery of the actual asset.

Risks of futures trading

Here are some pitfalls in trading futures contracts:

1. Not for beginners
   Futures trading is complex and better suited for those with experience. Your clients need to have a solid understanding of how these contracts work and should be comfortable implementing strategies that align with their risk tolerance.
2. Market volatility
   Futures prices can change quickly in response to economic, political, or other global events. This means the market might move against your clients faster than they expect, leading to sudden losses. Be sure to guide your clients in navigating such volatility.
3. Margin calls
   Using leverage can increase gains, but it also means losses can add up quickly. If your client’s account balance falls below the required margin, they will need to add more funds to keep their position open.

Why buy futures instead of stocks?

Futures contracts are not the same as stocks. When your clients buy stock, they are purchasing a share of ownership in a company. With futures, they are entering an agreement to buy or sell a specific asset at a set price on a future date. The asset could be anything from oil, corn, or even gold.

One reason why you might recommend futures to your clients is due to their flexibility. Futures contracts allow investors to take a position on the price of an asset without owning it directly. This can be useful for those who want to manage risk or take advantage of expected price movements.

For example, a farmer who is concerned about grain prices dropping might use a futures contract to lock in a selling price for their harvest. On the other hand, a bread company might buy that contract to secure its supply at a known cost.

Who participates in the futures market?

There are two main types of participants in the futures market:

1. Hedgers
   Hedgers are those who have a real interest in the underlying asset. They might own it already or plan to buy it in the future. Their goal is to lock in a price and reduce the risk of price swings.
   For example, a farmer might use a futures contract to sell their crop at a fixed price, while a food company might buy that contract to secure its supply.
2. Speculators
   On the other hand, speculators are looking to profit from price changes. They do not plan to take delivery of the asset. Instead, they buy and sell contracts based on their view of where prices are headed.
   Let's say that your clients think that the price of lean hogs will rise. As speculators, they might buy a futures contract and sell it before expiration to avoid taking delivery of thousands of pounds of pork.

Both types of participants play a vital role in futures markets. The hedgers are the ones who help stabilize prices. Speculators, meanwhile, add liquidity to the market.

Looking ahead with futures

The standardized nature of futures contracts and the liquidity of regulated exchanges make it possible for a wide range of investors to get involved—not just large institutions. The futures market’s nearly round-the-clock trading hours and its focus on both short-term and long-term price prospects set it apart from traditional stock investing.

Futures trading is also suitable for those who want to take a more active role in managing their financial exposure. And this is why becoming knowledgeable about this type of derivative is beneficial. When you know how to explain the mechanics of futures contracts, you can help your clients understand the details behind these agreements.

Finally, if you’re also able to discuss the motivations behind different trading strategies, your clients will be able to see both the possibilities and the risks.

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