A contract future is an agreement between a buyer and seller to trade an underlying asset at a predetermined price and date in the future.
For example, let’s say you want to trade crude oil futures. You enter a contract to buy one crude oil contract at USD 70 per barrel in three months’ time. One contract represents 1,000 barrels, so your futures contract is valued at USD 70,000. If the price of oil rises to USD 80, you can sell at USD 80, earning a profit of USD 10 per barrel, or USD 10,000 profit for the contract. On the other hand, if the price were to drop to USD 65 per barrel, you’d incur a loss of USD 5 per barrel, or USD 5,000 for the contract. If the contract is held at expiry, the P/L will be credited or debited from your account.
This example illustrates the speculative nature of futures trading, where traders aim to profit from anticipated price movements in underlying assets like crude oil.
Types of futures
There are different types of futures contracts available for trading, each representing a specific underlying asset:
- Index futures are based on a specific stock index, such as the S&P 500 or NASDAQ. Traders can speculate on the future direction of the overall stock market by trading these contracts.
- Bond and interest futures are tied to fixed-income securities, such as government bonds or interest rates. These contracts can be used to hedge against interest rate fluctuations or speculate on future interest rate movements.
- Commodity futures represent commodities such as gold, oil, natural gas, agricultural products or metals. Traders can take positions based on their expectations of the future supply and demand dynamics of these commodities.
- Currency futures involve the exchange rate between two currencies. Traders can profit from changes in currency exchange rates by speculating on the future value of one currency against another.
Trading futures with leverage
Futures are traded with leverage, which allows a trader to control a larger position with a smaller amount of capital. For example, let’s say you want to trade gold futures. The current price of gold is USD 1,500 per ounce, and the futures contract requires a margin deposit of USD 10,000. With a contract size of 100 ounces, you can control a futures contract worth USD 150,000 with just USD 10,000 of capital. If the price of gold rises by 2%, your gain would be USD 3,000 (2% of USD 150,000), a 30% return on your capital. You must therefore have sufficient collateral on your account to cover the initial margin in order to open a futures position, this must also be maintained to cover the margin requirements when/if holding the contract.
What causes futures prices to move?
A number of factors can drive price movements in futures, such as supply and demand dynamics, economic indicators, geopolitical events and market sentiment. For instance, a severe drought could lead to a decrease in crop yields in agricultural regions. Traders anticipating this could buy corn futures contracts, expecting the price to rise due to potential scarcity. Conversely, a bumper crop season, with an increased supply of corn, could lead to a decline in corn futures prices.
What are the risks of trading futures?
When trading futures, it’s important to be aware of the potential risks. These include:
- Market risk: Futures profit/loss values can be highly volatile and fast-moving. Leverage amplifies the effect of price changes on the underlying asset, and this can therefore lead to considerable losses. With prices influenced by a range of factors, including economic conditions, market trends and world events, traders should analyse the market carefully and use risk management strategies.
The potential for losses due to adverse price movements in the underlying asset. - Liquidity risk: Some futures markets may have lower liquidity, meaning there may not be enough buyers or sellers at a given price. This can result in slippage, where the executed trade price deviates from the expected price. Traders should therefore be cautious when trading in low-liquidity markets.
The risk that you may not be able to enter or exit a futures contract at desired prices due to low trading volume. - Counterparty risk: The risk that the counterparty (Central Clearing Counterparty for Listed Futures) may default on their obligations.
In addition, there may be other risks specific to trading futures, such as regulatory changes, volatility, interest rates, leverage and operational risks.
Other Futures trading risks include: - Execution risks: technical issues or market disruptions can impact trade execution.
- Regulatory risks: changes in regulations can affect Futures trading conditions.
- Psychological risks: Emotional decision-making and lack of discipline can lead to poor trading outcomes.
How much can you lose in futures trading?
When trading futures, the maximum loss you can face depends on the leverage used and the price movement of the underlying asset. Trading with leverage means that losses can exceed the initial investment or margin deposited, meaning there is no limit on the loss potential of the trade.
Additional costs and charges
Traders may incur additional costs such as commissions, transaction fees and financing charges. These costs vary depending on the market used for trading futures. If trading futures denominated in a different currency, conversion fees may apply. In general, you should review the terms and conditions of your chosen broker to understand the specific costs associated with trading Futures.
When holding a futures position, you need to ensure you have collateral on your account to cover the margin requirements.
Overall, when trading Futures, it’s important to thoroughly understand the product, conduct research and practice risk management.