What is futures trading and how to trade futures?

What is futures trading?

Futures trading describes the process of buying and selling an asset at a future date at a predetermined price. Futures contracts are standardised and traded on organised exchanges, such as the Chicago Mercantile Exchange (CME) for example. They are used by a variety of market participants, ranging from hedge funds trying to profit from short-term price movements to commodity houses and producers looking to hedge their risks.

Futures represent a contract, where the buyer is required to purchase the underlying asset and the seller to sell the underlying asset at the agreed price upon expiry. However, in practice, especially amongst speculators, physical delivery is uncommon. A retail trader or a hedge fund is unlikely to have the capability or desire to take delivery of tons of sugar or coffee — they simply want to profit from the price movements.

What is the futures market?

The futures market is a marketplace where participants buy and sell futures contracts. Futures trading is not conducted on one specific market, but across multiple exchanges spread around the globe. Some of the most famous exchanges are the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME), and the Chicago Board of Trade (CBoT).

Unlike currency trading, futures trading is centralised, and contracts are standardised. Exchanges are subject to strong regulation as they are a key part of the financial system. Some of the world’s most important assets, such as oil and gold, are traded on such exchanges.

Exchanges do much more than just provide participants with access to the futures market. They may also be involved in clearing and settlements, standardising contracts, and providing market data.

What are futures contracts?

Futures contracts are standardised agreements to buy or sell the underlying asset at a fixed price on a certain date in the future. There are several characteristics that differentiate futures from other financial products:

• Futures are standardised, meaning that the contract size, expiration date, and other specifications are known, and do not vary. In other markets, such as forex, trading is done over the counter (OTC) which allows market participants to tailor the product to their needs, such as a custom-made FX option contract.
• Futures are traded on exchanges and centrally cleared, with the exchange acting as the seller to every buyer and the buyer to every seller.
• Expiration date: Each futures contract has an expiration date after which the contract must be settled, either by cash or by delivering the underlying asset.
• Price: The price at which the underlying asset will be bought/sold is fixed and predetermined.
• Margin requirements: Futures contracts typically require more margin than FX-related products, and margin requirements can vary based on liquidity and market conditions.

Why trade futures?

Futures contracts are used by a variety of market participants who have different objections and needs.

Commodity producers use futures to hedge price risks rather than generate profits from trading. They want to hedge themselves against unexpected price movements that could leave them exposed. For example, a producer of sugar could suffer significant losses if the price of the commodity suddenly crashes. By taking a short position on the commodity, the producer can reduce this risk.

Commodity consumers also use futures to limit their exposure to sudden price movements. For example, airlines are exposed to the price of fuel, and factories are exposed to the price of electricity.

On the other hand, speculators such as hedge funds, prop trading firms, and individual retail traders try to profit from short-term price movements by buying/selling contracts without wanting to take delivery of the underlying asset.

Institutional investors like asset managers and pension funds are also present in the futures market, using futures contracts for portfolio diversification, hedging, or speculation.

How to trade futures?

Individual traders cannot trade on the exchange directly, they will need a broker. There are several brokers who can provide access to the futures market, and it is in the best interest of the trader to do thorough research on which broker best fits the requirements.

When choosing a futures broker you want to consider the following:

• Where is the broker regulated and where are the client funds held?
• Are the reviews posted by customers primarily positive, and are negative reviews addressed appropriately by the company?
• What are the trading costs and how do they compare to the competition?
• What trading platforms are available, and do they fit your needs?
• What research and educational tools does the broker provide?
• Does customer support reply to queries in a timely manner?

After you have done some research and narrowed down the list of potential brokers, it is time to test the platform with a demo account to better understand the advantages and limitations of the broker’s platform.

Once a broker has been chosen and the account has been funded, you can start trading. Which contracts should you choose? This will primarily depend on your strategy, trading style, and previous trading experience. For example, a trader who already has plenty of experience in trading currencies and gold may find it easier to transition to FX and gold futures.

Consider also the liquidity — contracts such as cocoa and sugar will be less liquid and will have more erratic price movements compared to highly liquid and heavily traded contracts such as the S&P 500 and oil futures.

Before placing a trade, you must make yourself familiar with the different contracts that exist.

Each contract has different characteristics such as dollar value per point, notional value, and expiry date. Traders will typically choose the contract with the nearest expiry date as that will be the most actively traded one.

Traders coming from an FX/CFD background will also have to get used to a different system of position sizing. There are no lots, but rather a number of contracts. Some contracts have a large notional value, which is why exchanges also offer mini and micro futures — essentially a smaller version of the original futures contract.

For example, the S&P 500 micro E-mini futures is 1/10 of the size of the original E-mini contract, which makes it more accessible to traders with smaller balances.

Example of a trade

Oil is currently trading at $80 per barrel. You have done your analysis and think that markets are underestimating the risk of further geopolitical tensions, which could lead to a sudden increase in oil prices.

To use this scenario to your advantage, you will buy the West Texas Intermediate (WTI) futures contract, which is traded on the New York Mercantile Exchange (NYMEX).

One contract is worth 1,000 barrels of crude oil, so the notional value is $80,000. You have $10,000 in your account and your broker requires a maintenance margin of $6,000, which means you have sufficient funds to open and maintain the position.

You place a buy order for one WTI contract with the nearest expiry date, as that is the most liquid. Your broker fills your order at $80.00. To protect your capital, you place a stop-loss order at $78. Your analysis tells you that $85 would be a good place to exit your trade, so you place your take-profit order there.

Scenario 1: Investors are increasingly concerned about rising geopolitical tensions, after previously underestimating the risk. Oil prices rise to $85, and your take profit order is triggered, netting you a profit of $5,000, as 0.01 per barrel = $10.

Scenario 2: Geopolitical tensions are starting to fade away, and investors are focusing on the oversupply of oil in the market, fueling bearish bets. Oil prices are sliding and with negative momentum accelerating, your stop-loss order at $78 gets hit. Your loss is $2,000, as 0.01 per barrel = $10.

Advantages of trading futures

• Futures can be traded around the clock, with the most popular contracts having only a one-hour break per day.
• Futures contracts are generally very liquid, particularly heavily traded ones such as the S&P 500, oil, gold, and major FX pairs.
• Futures contracts are available for a wide range of asset classes and instruments — currencies, commodities, interest rates, and stock indices. There are futures contracts based on orange juice, uranium, and even the weather!
• Futures are traded on exchanges, which are heavily regulated and well-capitalised. While you will still need a broker to access the exchange, traders can have peace of mind when it comes to price transparency.
• Low margin requirements, which allow traders to control positions far larger than their actual account balance. Using leverage can increase potential profits, amplifying potential gains, but also losses.
• Flexible contract sizes, with micro and mini contracts available for major instruments.

Disadvantages of trading futures

• The concept of contracts, i.e. the same instrument having multiple contracts with different expiry dates and contract sizes, can be confusing to some, particularly if they come from an FX spot background.
• Futures contracts have expiration dates, which traders must keep in mind, particularly if they intend to keep their positions open for a long time.
• While exchanges are highly regulated and well-capitalised, traders are still exposed to risk by using a broker. Futures brokers are not immune to issues, as seen in the case of MF Global, a major derivatives broker that went bankrupt in 2011.
• Leverage can make futures trading highly risky. Traders with a focus on CFDs or similar derivatives are familiar with the risk, but those who trade unleveraged products, such as physical stocks, should first study the effects of leverage.

Best futures trading strategies and techniques

Futures contracts are instruments to trade a variety of markets, and there is no trading strategy that is unique to futures. The trading strategy or technique a trader should use depends on the trader’s risk profile, personal preferences, and the underlying asset traded. 

Some of the popular trading strategies that can be applied in the futures market — amongst many other markets — are trend following, breakout trading, scalping, and algorithmic trading.

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.