Futures trading can make you lots of money really quickly, but this ‘high-risk, high-rewards’ activity is only suitable for traders of a certain nature. Here’s an in-depth guide on what futures trading is and how to start.
Originally created as a way for organisations to hedge against price swings in the commodities markets, futures trading is growing in popularity among retail investors around the globe.
The proliferation of online brokers and leveraged trading, along with the promise of quick, large profits, no doubt is fueling demand.
But how does futures trading actually work, and is it a suitable type of investment for you?
In this article, we will cover:
- The difference between futures and options
- How futures contracts work
- How futures trading works
- Risks and rewards of futures trading
Futures vs options - what’s the difference?
You may notice that futures and options are often mentioned in the same breath, leading you to believe that they may be somewhat related. That’s not far from the truth - they are, indeed, very similar trading products.
Here have a look.
|Contract to execute a trade at a future date
|A contract in which you have the right to buy, but there’s no obligation to do so
|May exit the futures contract by closing your position
|May exit the contract by leaving the option to expire, losing only the premium
|Initially created for institutional traders, but rising in popularity among retail traders
|Popular investing method among retail and institutional traders
|Simpler to understand, but regarded as riskier than options
|More complex and technical, but considered less risky than futures
|Marked to market daily, i.e. price movements are settled at the end of each trading day
|Settlement is done only at the end of the contract
As stated above, both involve a contract to trade an asset, but the essential difference is as follows:
- an option gives you the right (but not the obligation) to execute the trade; you can choose to let the options expire
- in a futures contract, you are obligated to make the trade on a future date; unless you close your position prior to expiration
It is helpful to think of options and futures as both sides of the same coin - in fact, options are bought and sold on futures.
Another thing to note is that while a futures contract is simpler to understand than an options contract (the latter has more jargon, and a higher number of possible outcomes), they are often seen as riskier.
That’s because once you’ve entered into a futures contract, you either go through with the contract - no matter if it’s favourable or not - or you close your position, which means having to settle your account.
But we’re getting ahead of ourselves. Let’s break down exactly how futures work. Hopefully, it’ll all make sense by the end.
How do futures contracts work?
The structure of a futures contract
A futures contract is quite simple, really. It’s a legally binding agreement between a buyer and a seller to trade a specified amount of a specified asset at a specified price on a specified date. The method of settlement must also be specified.
Consider this scenario: Starbucks enters a futures contract to buy 1,000 tonnes of coffee beans from a supplier, BeanGrower Pte Ltd, at the price of S$50 per tonne, in 30 days’ time.
So after 30 days, Starbucks will receive the coffee beans and BeanGrower will get paid. Starbucks takes their beans and brews more cups of coffee to sell to its customers, and BeanGrower takes their money to grow more beans (probably). Everyone is happy.
Or are they?
A futures contract generally favours one party over the other
You may have noticed that there are more than one coffee bean supplier in the market, and as such, the price of coffee beans can move up or down. Now here’s where the magic in a futures contract happens.
Let’s go back to the day the contract is due. Assuming that the market price of coffee beans that day is S$60 per tonne, Starbucks actually got the better deal - they bought what they needed at a 20% discount.
This also means that BeanGrower got the raw end of the deal - they could have made more money on their 1,000 tonnes of beans, had they sold it on the open market.
Now, what about if the price of coffee beans has moved down, to say, S$45 per tonne? In this case, Starbucks went away unhappy, as they paid more for the commodity, than if they had purchased on the open market.
In this scenario, BeanGrower went away happy, as they managed to get a better price for their beans than if they had sold on the open market.
So what happens if the price of the coffee beans stays at S$50 per tonne? In this case, both got exactly what they bargained for.
Futures allow businesses to hedge against price volatility
So why can’t Starbucks (or for that matter, BeanGrower) buy or sell on the open market?
Because Starbucks may not be able to get the beans they need on that day - which would be disastrous for their business, as no beans means no business.
Similarly, BeanGrower may not be able to find a suitable buyer in time, resulting in the loss of their stocks - and therefore revenue - due to spoilage.
However, by entering into a futures contract, both Starbucks and BeanGrower guarantee themselves of a trade that is crucial for the continuation of their business.
As you can see, a futures contract allows an organisation to hedge against price volatility, which many sectors and enterprises are sensitive to. This is why futures trading was originally created for institutional traders.
How does futures trading work?
Now that you understand how a futures contract works, let’s move on to futures trading, which bears some crucial differences.
Here are the steps involved in futures trading.
Step 1: Open and fund your account
If you haven’t already, you can open a trading account with an online broker offering futures trading.
You’ll also need to deposit a certain amount of funds into your account to start trading. This amount is subject to a minimum, which varies according to brokerages.
Should your account balance fall below this minimum amount, a margin call will likely be triggered (more on this later).
Step 2: Pick a suitable futures contract
Next, pick a suitable futures contract, and then open a corresponding position. You may take a long position or a short position.
- Long position - you expect the price of the underlying asset to go up, and make profit when it does
- Short position - you expect the price of the underlying asset to go down, and make profit when it does
Step 3: Get ready for mark-to-market
And here’s where the roller coaster ride starts, so strap in.
Now, in futures trading, mark-to-market is practised, which means that your account is settled up at the close of every trading day. This is what it looks like in action.
Let’s assume that you decide to trade futures for wheat, which you think will go up in price.
You decide to buy five contracts of wheat (1 contract = 2,000 bushels), and the current price is S$3 per bushel.
Therefore the total value of your futures contracts is 5 x 2,000 x S$3 = S$30,000.
|Account balance at end of day
In mark-to-market the profit or loss of the day is determined by how much the price has changed from the previous day.
However, your position for the day always corresponds to the price of the asset at the start of the contract. For example, on Day 4, there was an increase from S$3 to S$3.20, hence your account balance was S$32,000 for the day. On Day 6, there was a decrease from S$3 to S$2.50, hence your account balance was S$25,000 for the day.
This behaviour reflects how futures contracts work.
Crucial implications of mark-to-market
Now, assuming you encounter a prolonged run where the market goes against you, you can see that your account balance will drop very quickly. This could trigger a margin call, which will require you to top up more money in order to hold on to your trade.
Failing to meet a margin call will cause you to close out your position, at which point you are likely to make a huge loss.
Another implication (as seen in the example above) is that your account balance is updated at the close of every day. This means that any profit or loss is immediately realised.
This should set off warning bells for those of you who are risk-averse. Unlike buying and holding stocks, there’s no waiting around for the market to recover to make up for any unrealised loss. Whether you want it or not, losses are deducted from your account at the end of the day.
On the flip side, any profit for the day is also automatically credited, which has the effect of generating instant cash for you, which is undoubtedly an attractive proposition.
However, always remember that whether you make a profit or loss in total depends on the price of the asset at the time you close out your position.
Step 4: Close out your position
While we’ve stopped our hypothetical example at Day 10, in practice, this daily settlement of your account carries on every day until you close out your position or the contract reaches its end date, on which a final settlement is performed.
Seeing that the average retail futures trader has no intention of taking delivery of the asset they are trading (they’re just in it for the potential profit), it is important that you pick cash settlement as the final settlement method (instead of delivery of goods, aka physical settlement).
When you close out your position, you can do so either by opening an opposite position in the same contract, or selling your contract on the market to someone else.
This will trigger a final settlement, with your account balance reflecting any corresponding profit or loss.
Risks and rewards of futures trading
Use of leverage is common
Trading futures requires a substantial capital outlay up front, which sets a high barrier to entry for the average trader. To circumvent this, many brokerages offer leverage, which means they loan you the funds needed to open your position.
More so in futures trading than in other investing methods, leverage rates are high in futures - as high as 10 times or even 20 times. Leverage allows you to start futures trading with a relatively small starting capital and, if successful, generate massive profits quickly.
However, losses are similarly amplified, which could place you in financial danger.
Futures trading is volatile
To call a spade a spade, futures trading is basically gambling. Because there’s no way to predict the price of any given asset at the close of any given day, all you’re doing is simply placing bets.
Granted, you can attempt to hedge your risk by taking different positions in multiple contracts, and there are also tools you use (such as limits or stops) to help manage your risk.
But there’s no ignoring that a small movement in price will create a large change in your account balance, which is further amplified if you are trading on leverage.
And let’s not forget that any losses are realised immediately, thanks to the mark-to-market characteristic of futures trading, which creates the ever-present risk of margin calls. This demands the ability to remain financially solvent throughout bad markets.
Then again, while the downside potential is high, the upside is similarly attractive. There is some real potential to make serious bank.
All said, futures trading is a high-risk, high-reward activity. It certainly isn’t for beginners, and you definitely shouldn’t put in money you can’t afford to lose.
If you’re interested in trying your hand at futures trading, be sure to learn as much as you can, arm yourself with risk-management strategies, and maybe dip a toe in to test the waters before making any large commitments.
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