When you hear futures, what comes to your mind? Well, you might think of “future” as in “future tense” and you would not be too off-point. However, to be specific enough, futures are a financial asset traded in the form of contracts.Those contracts are executed on an exchange.
A futures contract operates as a standardised agreement between two parties to buy or sell an asset at a future time and at an already decided price. Those assets belong to a wide range of categories and can be orange, wheat, soya beans, oil and even pork bellies!
Unlike most other financial markets, the futures market can easily operateas a physical one in the sense that the parties involved can decide to take the actual delivery of thetrade commodity.
For example, a party that wants to buy a commodity will strike an agreement with another party who is willing to sell. He will then take delivery of the given commodity from the selling party at a future date.
How Futures Work
So, how do futures work? And why should you trade them? You might want to know. First, futures, because they are contracts that have to be fulfilled at a future date, can serve as a useful hedge against inevitable wild changes in price.
Futures can conveniently serve this purpose as the price of the underlying commodity would have been earlier agreed upon by the two parties concerned. Check this hypothetical example out:
- A yogurt manufacturing company seeking to have a bargain on the price of milk and hedge against any potential wild swing in its price. The company can, therefore, agree to buy a set quantity of milk to be delivered at a set future time at a specific price.
- On the other hand, a dairy farmer who is afraid that the price of milk might drop can decide to sell a dairy futures contract. This will serve him in two ways: first, he will have an already set buyer for his product;second, he will be hedged against any drop-in price during the period over which the contract is held.
However, beyond the cheese/yoghurt-manufacturing company and the dairy farmer are the futures speculative traders who are not interested in taking the physical delivery of any milk. This category of individuals only participates in the futures market to take advantage of the changes in price.
Although the futures market is relatively liquid, you must note that the liquidity varies with the asset being traded. For example, corn and soya bean futures contracts are more traded than dairy contracts.
Explaining Futures Contracts
Future contacts are standardised. Hence, they always include details such as the unit of measurement of the commodity being traded, the terms of settlement of the trade, the currency in which the futures contract is quoted, and the exact quantity of the commodity to be delivered.
Their traders use margin and leverage in their trades. These two tools, which are like borrowing money upfront, enable them to increase their profit potential. However, they also magnify their potential for losses, too.The good news is that leverage and margin trading offerings in the futures markets are reasonably high.
How Futures Trading is Done
Arguably, futures might be the easiest asset to trade. All you have to do, as with other asset classes, is to search for a well-regulated futures broker of good repute and open an account with it. First, before you do, you must confirm that the broker supports the markets you wish to trade.
Most likely, the broker will send you a checklist of important questions about yourself to answer. Questions like; what is your risk appetite like? What is your net worth? How much is your trading experience? For how long have you been investing?
The essence of those questions is for the broker to be able to provide services that will be appropriate for your situation. And you should note, the futures brokerage industry is full of varying services.
As a result, if you check, you should not be surprised that different futures brokersoffer slightly varying services for their clients.In spite of that, however, ensure that the broker you use provides some other additional services that will enhance your trading. These include research and analysis tools to help you make informed decisions about the markets you trade.
Moreover, does the broker have a virtual trading arrangement? This is a form of practice trading that will enable you to familiarise yourself with the tools and also the fee regimen of the broker before you get to commit your real money. Virtual trading is done with “paper money” so it is absolutely risk-free.