What is a Future
A future is a type of security that grants the trader the right to buy or sell something at a fixed price on a specific day in the future. That something is normally a commodity like gold, corn, crude oil, bonds, international currencies, or major market stock indices. Futures prices are derived from cash markets which is why they are called a derivative.
Futures are traded by three main groups of traders:
The first is large commercial traders who buy and sell futures to hedge and lock in prices for commodities they produce to use in their operations. Someone who grows coffee might want to lock in a high price at harvest time by selling a futures contract, and Starbucks might want to hedge their costs at lower prices to better manage their budgets and expenses by buying a futures contract.
Large speculative traders are the second group of futures market participants – trading on the direction of prices. Commodity trading pools are an example of a large futures speculator.
Small speculators are the third group, retail traders like you, also trading on the direction of prices.
Futures are traded on various exchanges throughout the United States and internationally, the largest of these exchanges is the Chicago Mercantile Exchange (CME). As a retail trader, keep in mind most futures markets are dominated by the commercial traders, accounting for 75 to 90 percent of all futures trading volume. Futures are generally traded in a separate futures account with a futures broker dealer.
Each futures contract has unique contract specifications, it is important you research the specifics of each market you want to trade. Each futures contract has an expiration date of when buyers and sellers must notify the exchange if they are going to take delivery of the commodity represented by the futures contract.
To trade any futures contract, traders are required to put up a good faith deposit called margin, which sets aside money in your account in the event of losses. For example, to trade one crude oil contract would require $5,000 of margin in order to control 1000 barrels of crude oil. A crude oil futures contract represents 1000 barrels of crude oil which has a value of approximately $60,000 (1000 X $60 per barrel). Each full 1-point move is $1000 profit or loss per crude oil contract. Day traders who do not hold their position overnight get a reduced margin rate of 12.5 to 25 percent of the overnight rate.
Learning which futures to buy or sell and when to buy or sell, when to hold your position and when to close your position requires knowledge and experience you can gain through education and coaching.
Why Trade Futures
Futures offer a number of advantages over trading stocks or other financial instruments.
Diversification – Generally, when the stock market goes up or down, most stocks go up and down along with it. At times, traders can experience wide swings in your account value, especially if your stock portfolio is weighted heavily on one side of the market when the market is moving in the opposite direction. By trading futures uncorrelated to the stock market, you can help reduce your portfolio’s volatility and overall risk.
24-Hour Liquid Markets – How often have you seen a news event after market hours or over the weekend and wished you could trade that news before the stock market opens on Monday? Many futures markets trade 24 hours a day six days a week starting on Sunday night through to Friday’s close. Futures are also very actively traded, and the large number of traders generally ensures tight bid-ask spreads, fair transparent pricing, and large trades can be executed without wild price fluctuations.
Leverage – Futures are traded on margin which allows you to control a large dollar value of a commodity or stock index for a fraction of its value. This can result in much greater profits than could be gained without margin. With margin also brings potential for larger losses if the trade moves against you. Always have appropriate risk management in place to guard against a big move against your futures position. It is always possible to lose much more money than the initial margin required at the start if the market makes a big move against your position.
Tax Benefits – Futures traders benefit from a more favorable tax treatment than short-term stock traders; 60 percent of futures trading profits are taxed as long-term capital gains regardless of how long the trade was opened, and the remaining 40 percent of profits are taxed as short-term capital gains. Currently the maximum long-term capital gains rate is 15 or 20 percent, and the maximum short-term capital gains rate is 37 percent. Always check with your tax professional for the current tax rates and how any trading will affect your tax return filings.
Pure Market ExposureA stocks or ETFs trader seeking exposure to crude oil would have a number of challenges. Oil refining stocks are highly diversified beyond crude oil, an Exchange Traded Fund (ETF) like USO uses futures and swaps to create a crude oil price proxy and often these instruments do not directly reflect the price action of the crude oil market. On the other hand, the crude oil futures trader receives pure exposure to the crude oil market. Each crude oil futures option controls one crude oil future made up of 1,000 barrels of West Texas Intermediate crude oil.
What You Need to Know About Trading Futures
Trading futures requires you learn how to trade futures, learn about the markets, learn what drives futures prices, and learn how to decide which futures contracts to buy and sell.
Experienced futures traders always have a plan before entering a trade. This plan includes how many contracts to buy or sell, how much risk they are willing to take, how much money they are willing to lose on a single trade and a price level to take profits.
Understanding how futures trading works is a key factor to consistent trading and avoiding mistakes. Each type of futures contract has its own unique contract specifications which you need to fully understand – futures can trade at odd times during the day, each future has both a specific and unique last trading day and expiration day, which can be different and each futures contract has a unique contract point value which determines the profit and loss of a position based on the price action.
Finally, you might have heard stories of the absent-minded futures trader who forgot to close his lean hogs positions and a truck pulled up a few days later to his house to deliver the hogs. Although I guess this could happen, most online brokers are looking out for you in these circumstances and will auto close positions before the delivery notice is required (but it is a funny story).