Basics for Individuals Looking to Use Futures in Investing
Should you use futures in investing your portfolio? Futures trading can be an exciting and potentially lucrative investment opportunity for those who are willing to assume the risks involved. The contracts allow investors to trade a wide range of assets, from commodities like oil and gold to financial instruments like stock indices and currencies. Below we’ll explore what futures trading is, what types of assets are traded in the futures market, the advantages and disadvantages of futures trading, and what beginners should know about trading platforms and the Chicago Mercantile Exchange (CME).
Background
Futures were originally designed to allow buyers and sellers of raw materials to lock in a price and know their future costs to avoid being impacted by factors affecting the commodity’s price, like weather. The market later grew to help other businesses, such as utilities and airlines, hedge against unknown fuel costs – and the products continue to expand today. Currently, futures are being used by all manners of investors, speculators, and those that want to hedge against the risk of future cost spikes.
This has made for deep markets, the trading volume in futures contracts, is now often a multiple of the trading of the underlying physical assets. This is the case with oil futures contracts. The addition of professional and individual investors and speculators has dramatically increased trading volume. This helped make the financial products extremely liquid compared to when they just functioned as insurance against manufacturing price risk.
It is no surprise, then, that many speculators are drawn to futures trading, both for the potential of outsized profits and the ability to have exposure to assets that may otherwise not be accessible to the investor.
What is Futures Trading?
A futures contract is an agreement to buy or sell an asset at a specified price and time in the future. Futures contracts are traded on organized exchanges, such as the CME, which provide a platform for buyers and sellers to trade contracts. Unlike stocks or bonds, futures contracts are derivative products, meaning that their value is derived from the underlying asset. The underlying asset can be a physical commodity, such as gold or oil, or a financial instrument, such as a stock index or a currency.
Terms Used in Futures Trading
Before making any transaction, especially investing in futures contracts, it is critical to understand some of the most used key terms in futures trading:
Contract Size: The amount of the underlying asset covered by one futures contract.
Contract Expiration: The date when the futures contract expires.
Margin: The amount of money an investor must deposit to buy or sell a futures contract.
Settlement: The process of fulfilling the terms of a futures contract by exchanging the underlying asset or its cash value.
Types of Assets Traded in the Futures Market
As mentioned earlier, there continue to be new types of futures contracts being brought to market. The futures market offers a wide range of assets that can be traded through futures contracts. Some of the more commonly traded assets among self-directed traders include:
Commodities: Futures contracts are frequently used to trade commodities like crude oil, gold, silver, and agricultural products like wheat and corn.
Financial Instruments: Futures contracts are also used to trade financial instruments like stock indices, bonds, and currencies.
Advantages and Disadvantages of Futures Trading
Like any investment opportunity, futures trading has its advantages and disadvantages. Here are a few of the key advantages and disadvantages of investing in futures contracts:
Advantages:
Leverage: Futures contracts offer investors the ability to leverage their investment, meaning that they can control a larger amount of the underlying asset with a smaller amount of capital.
Diversification: Futures contracts provide investors with a way to diversify their portfolio by investing in a wide range of assets.
Liquidity: The futures market is highly liquid, meaning that investors can easily buy and sell contracts without impacting the market.
Disadvantages:
Risk: Futures trading is a highly speculative investment opportunity and involves significant risk. A futures position can also quickly turn against you – the high leverage could make matters worse this is because margin magnifies both profits and losses.
Complexity: Futures trading can be complex and requires a good understanding of the underlying asset and market conditions. Often there are factors that impact price movements that are well beyond the ability of an individual to account for.
Costs: Futures trading can be expensive, while commissions on future trades are very low and are charged when the position is closed, usually as low as 0.5% of the contract value, the spread between the bid and offer may be wide which could impact costs when it’s time to close out the position.
What is the CME?
The Chicago Mercantile Exchange, or The Merc is one of the largest and most well-known futures exchanges in the world. It offers a platform for trading futures contracts on a wide range of assets, including commodities, financial instruments, and currencies. The CME also provides a range of resources for investors, including market data, trading tools, and educational materials.
What Should Self-Directed Investors Look for in a Trading Platform?
Self-directed investors who are interested in trading futures contracts should look for a trading platform that doesn’t limit their growth as a trader. As such it should offer a range of broad range features and resources. Here are a few key features beginner futures traders look for:
Easy-to-use interface: Auser-friendly interface can make it easier for investors to navigate the trading platform and place trades. A complex and confusing interface can make it difficult for investors to execute trades quickly and efficiently, which could result in missed opportunities or costly mistakes. If you are currently using a platform for stock trading, see if they have ample futures capabilities. At times, comfort and familiarity navigating a platform can make all the difference.
Mobile compatibility: Many investors prefer to trade on-the-go using their mobile devices. A good trading platform should be compatible with mobile devices, allowing investors to monitor their trades and make trades from anywhere with an internet connection.
Access to market data: This would seem basic, but access to real-time market data, including price quotes, charts, and news feeds, is essential. This information can keep you looking at what is occurring now, not 20 minutes ago before a market-moving economic report was released.
Advanced order types: The ability to place advanced order types, such as stop-loss and limit orders, can help investors manage their risk and control their trades more effectively.
Educational resources: Futures trading can be complex and requires a good understanding of the underlying asset and market conditions. A good trading platform should provide investors with access to educational resources, such as articles, tutorials, and webinars, to help them learn about futures trading and stay up-to-date on market trends.
Commission and fees: Trading fees can add up quickly and eat into profits. It is important to choose a trading platform that offers competitive commission and fees, without sacrificing the quality of service or features offered.
Take Away
Investing in futures contracts has developed to include many different underlying asset types. It has also become much easier for the individual and average investor to be involved. The leverage magnifies moves, this can be a high-risk, high-reward trading experience.
Before investing, it is important to understand the risks and benefits of futures trading, as well as the key terms and concepts used in the futures market. Choosing the right trading platform can also be crucial to success, as it can provide investors with the tools, resources, and support needed to make informed trading decisions and stay ahead of the market.
Managing Editor Channelchek
Sources
https://www.cmegroup.com/trading/why-futures/get-started-trading-futures.html