The broadly defined futures market is a market of nearly impossible scope. You can trade future contracts for just about anything — any number of currencies, commodities like wheat or corn, livestock like lean hogs, stock market indices, bitcoin, crude oil, even next year’s average temperatures in certain cities.
That’s right, you can buy and sell financial instruments that base their value on the upcoming weather.
Futures trading has a niche for just about everyone.
If you’ve got a trick knee that throbs before a cold spell, a keen nose for the bacon market, or impeccable intuition for the future worldwide demand for wool, you can make money in the futures market.
Be forewarned, however, the futures market entails significant risk and is not suitable for all investors. Make absolutely certain you understand both the financial instrument itself and the underlying asset before you begin trading.
Quick and dirty definition
Futures are financial contracts that obligate the holder to buy a product at a specific date in the future at a specific price that’s set today.
Here’s a silly but accurate example: Let’s “pretend” I’m a fan of one of football’s worst teams, the New York Jets. I am planning to go to a game next year when I’m in New York, but tickets are not yet on sale for next season. I’m a cockeyed optimist and I think the Jets will win the Super Bowl this year which will send ticket prices skyrocketing.
To protect my future bank account, I want to lock in a price today, while the Jets are still on the cusp of greatness, but not quite there yet. My friend Steve is a Jets fan who has two season tickets at a current rate of $80 per seat, but the Jets have been such a letdown that he usually tries to sell them. I can make a futures contract with Steve stating that when he receives his tickets for that game, I will buy them for $100 each.
That’s a futures contract.
Steve is betting that ticket prices will stay the same or decrease, and I’m betting that ticket prices will rise.
If I’m right, and ticket prices double after a Jets Super Bowl triumph, I just made a great deal because I have $160 seats for $100. If Steve is right and the Jets remain stuck in their decades-long morass and ticket prices remain unchanged, he made a good deal and I should have waited.
You can substitute corn, bitcoin, cattle or anything else for the Jets tickets and get an idea of how futures contracts work.
Futures trading in practice
Of course, when you trade futures in real life, you won’t need to find a Steve who has the opposite opinion of the future price of something. Exchanges such as the Chicago Mercantile Exchange list standardized contracts for different commodities and you can simply buy or sell through a brokerage account.
In most cases, you are actually buying directly from the exchange, as they momentarily buy the contracts from the person who wants to sell them and hold them just long enough to sell them to you. This eliminates any risk to the trader that the seller won’t follow through on the sale or the buyer won’t produce the necessary funds.
Exchanges further ease the process by providing uniformity to futures contracts so that you don’t have to haggle over exactly how many bushels of wheat or other commodity or asset will be included in each contract, or determine when the contract will be settled.
For example, soybeans are a typical commodity for which you can buy a futures contract on the Chicago Mercantile Exchange. Each contract sold is for 5,000 bushels of soybeans to be delivered at a specified date.
Keep in mind that with a futures trade, actual delivery of the underlying commodity will happen if you don’t unwind your position. If you buy one soybeans contract and unless you sell the contract before delivery, you will actually receive 5,000 bushels of soybeans! I’m not even exactly sure how much a bushel is, but that seems like a lot of soybeans to store in your garage.
More than 97% of futures contracts are settled before any physical delivery takes place and the vast majority of those who take futures positions only want to profit off the changing price of the contract rather than physically receiving and reselling any sort of commodity.
The value of your futures contract will change as the price of the commodity fluctuates. If a drought wipes out a lot of soybeans and if the price of the remaining crops rise, your contract itself will have value because you have the right to purchase soybeans at the lower price. You can then sell this contract to realize your profit.
Types of futures traders
Generally speaking, people who trade futures fall into two categories. There are the hedgers and the speculators.
Hedgers are those who try to protect themselves from market risk. For example, if you are a farmer and you are worried that the price of corn is going to go down before you bring your corn to market, you could buy futures contracts to lock in what that price will be. That eliminates the risk of the price falling and also eliminates any uncertainty. You know exactly how much you’ll make.
You can hedge your risk for anything that you can find futures contracts for. If you are an importer/exporter like the famous Mr. Art Vandelay, you might have significant currency risk. You can buy forex futures to lock in an exchange rate today.
Hedging eliminates or mitigates risk, and futures are excellent in that capacity.
On the other side, there are the speculators. They are the ones willing to take on that risk, in the hopes of getting a financial reward.
Speculators believe an underlying security or underlying commodity will rise or fall in price and so they buy or sell futures in order to profit on their belief.
In our Jets example above, I was hedging — trying to eliminate the risk that Jets ticket prices would go up and Steve was speculating — he was trying to profit because he believed prices would actually stay the same or decrease.
Advantages to trading futures
Why trade futures? One of the biggest advantages of futures trading is that you get to take direct positions in commodities and assets you’d never be able to access if you just bought and sold individual stocks on the stock market. As I’ve already mentioned, you can profit off the weather, meat prices, fruit prices, crypto currency prices … the list is endless.
The other great advantage to trading futures is that you can buy on margin. Buying on margin means that you don’t pay for the full value of the contracts you are purchasing.
For example, let’s say a bushel of soybeans goes for $10, which means one futures contract would be worth $50,000 of soybeans (each contract is 5,000 bushels if you recall). The percentage varies depending on the commodity, but typically you only have to put down 2%-12% of that $50,000 as an initial margin requirement. For simplicity’s sake, let’s say the initial margin requirement is 10% for soybeans, so you only need to put down $5,000 for a futures contract for $50,000 worth of soybeans.
That, my friends, is what’s known as leverage. You can take very large positions for very little cash.
It is not quite that simple, however. There’s also a maintenance margin requirement. After the initial margin requirement is taken from your account to be held as a deposit, your account still must meet maintenance margin requirements. This amount depends on a number of factors, but in our soybean example, let’s assume the maintenance margin requirement is an additional $5,000. That means the value of your account must stay above $5,000 at all times.
If your soybeans contract (or other positions you may have) loses enough money so that your account balance falls below $5000, you must deposit additional cash into your account or sell your position. This is the dreaded “margin call.”
If you don’t have enough money to meet your margin requirements, you could be forced to liquidate your position or other positions at a loss.
Leverage is a double-edged sword. Yes, it can multiply your profits and make you a very rich trader. It can also multiply your losses, which leads us to …
Risks to trading futures
With great leverage comes great responsibility. Do not trade futures without understanding the significant risk.
With a 10% initial margin requirement, you are leveraged 10:1. That means a 10% drop in prices would lead to a 100% loss of your investment. If you can’t make your margin calls, you’ll have to liquidate and you’ll lose it all.
And it could get worse.
In a worst-case scenario, you can lose even more than you invested. A crash in the underlying market or commodity for which you have a futures contract could leave you in debt to your broker if you don’t get out in time.
One bad futures trade can be a financial disaster, so proceed with caution. Do a very honest assessment of your risk tolerance before making any futures transactions.
How to get started trading futures
You can trade futures with a number of different brokerages, although you will be subject to minimum account balances and many brokerages will also perform credit checks and try to assess your risk tolerance and familiarity with futures.
Many brokerages and even some exchanges offer the chance to “paper trade” or make practice trades with a virtual account. This is an excellent opportunity to get familiar with the mechanics of a particular trading platform, learn how to read quotes, and test out your trading strategy. I strongly suggest you take this opportunity.
I’ll be publishing my reviews of different futures brokers in the near future, please check back. I promise I won’t mention the Jets again.
Another way to access the futures market is through proprietary trading companies — something you can learn about here.
Since futures trading can be quite complex and entails risks that can go far beyond simple stock trading, there are substantial opportunities for unscrupulous brokers and fund managers to try and take advantage of newcomers to the futures market.
Fortunately, there are several regulatory bodies that protect both individual investors and futures markets in general. The Commodity Futures Trading Commission (CFTC) regulates the industry as a whole, provides market data, and is a great overall resource for anything regarding futures markets.
The National Futures Association (NFA) maintains a database of registered futures traders and brokers. If you’re receiving investment advice about futures accounts or are considering investing with a commodity pool operator (CPO), make sure the broker/advisor is registered with the NFA.
Watch “Trading Places” with Eddie Murphy and Dan Aykroyd. Seriously. First off, it is hilarious. Eddie Murphy is at his best. Secondly, the depiction of futures trading is realistic enough that the movie is on the curriculum in futures and options classes at some of the top business schools in the country.
You should definitely do a little more research beyond this movie before you start trading futures, but it is a hilarious introduction to the lives of futures traders and it even has a lesson or two about formulating a trading strategy and taking advantage of market volatility.