What is futures trading? How do I trade the futures markets?
Futures trading is one of the varieties of making a profit on the exchange. Futures is a contract to buy or sell an asset on a specific date at a specified price. As a rule, we are talking about the current market value. The subject of trade can be stocks, bonds, currency, “rates” on the weather, inflation, and other economic/social/natural indicators.
Features of futures trading
The planting of wheat has just been completed, the conditional price for the current moment is 50 rubles. per ton. The forecasts for the summer are excellent, guaranteeing a high harvest, but in the fall the price is expected to drop to 30 rubles, which is absolutely not interesting for the farmer since it is more profitable for him to agree immediately on the supply of a certain volume of wheat for 50 rubles than to wait for the inevitable price drop.
In this example, the farmer is the seller of the futures contract.
Trading on the exchange provides traders with a guarantee of adherence to the rules of the standard future. In particular, the possibility of early termination of the agreement with the cancellation of obligations between both parties to the contract is allowed. A standard form of the document is used that complies with legal regulations (only the price of assets changes). All work is carried out in accordance with the rules of the exchange.
Several standard terms are used in trading, such as the volume of the underlying asset, the tick size, the minimum change price, margin, maturity date, contract trading time, price fluctuation limits. The effectiveness of futures trading depends on the degree of mastery of these concepts, so before investing large amounts, it is worth experimenting with small volumes.
Benefits of trading futures
Unlike the Forex market, futures trading involves a whole number of assets (without splitting into parts). This approach simplifies planning because a futures contract for 10,000 conventional units always means buying/selling exactly 10,000, not 7,000 or 4,000. Both parties benefit from a standardized trading process.
The most attractive features of futures are:
- The ability to instantly close a deal.
- Free increase in quantity.
- Simple settlement system.
- Admission to the exchange of companies and individuals that do not have exchange-traded assets.
Trading is carried out according to a standard agreement, there can be no “surprises”, as well as uncoordinated changes in the terms of cooperation. The exchange has an insurance fund confirmed by guarantees from the Obligations Clearing House. The trader chooses the leverage at his own discretion, its size significantly exceeds the maximum for working directly with the underlying asset, but one should take into account the increased risks when choosing large leverage – getting rich quickly can easily turn into an instant loss of the entire deposit.
Any contract has an end date of execution. Such a time limit makes it possible to plan a trade and get a predictable result. The trader gets access to instruments from all over the world, which allows him to diversify risks. The reality of the transaction is supported by the collateral provided, which is kept on the balance sheet by the “third party”.
Different trading strategies are applicable to futures. One of the options was mentioned as an example of a futures contract (the case of the wheat price-fixing on the day of the contract). This approach is called risk hedging. By opening a trade aimed at offsetting price risks, the trader provides protection against unpredictable spikes in the prices of traded assets.
The hedging mechanism assumes a balance of liabilities and “play” in opposite directions in order to achieve a minimum level of risk. The trader should take into account that this instrument can also reduce the profitability of the trade. The hedge will be profitable or unprofitable depending on the correct time of closing the contract.
The closer the delivery time of the futures, the lower the need for insurance of the transaction, which is reflected in the need to close the hedge shortly before this date. The later this is done, the lower the profit will be (if the situation develops favorably) or the smaller the losses will be (if we are talking about a negative change in the price of an asset). After the hedge is closed, there is the option to re-purchase / sell the hedging futures contract.
The second option for making a profit from each futures contract is to carry out a series of speculative operations, the key instruments of which are the liquidity of the asset and the maximum possible “leverage”. Speculation is short-term trading aimed at extracting profit from the difference between the purchase and sale prices of contracts.
Speculative trading is distinguished by the following criteria:
- Minimum position holding period. Requires constant presence in front of the terminal.
- The need for short-term changes in the price of the selected asset. If the market is calm, then the speculator has nothing to do with it.
- Maximum profit potential in a short time. With a timely exit from the market with the cancellation of contracts, you can generate many transactions with the maximum profit.
The trading technique is simple – when predicting an increase in price, a trader first buys a cheap futures contract, and then it is sold at a higher cost. With opposite forecasts, it is required to sell expensive futures, and then buy them at a reduced price.
Depending on the selected time period, technical or fundamental analysis (FA) can be applied. The first is better suited for short-term trading, while lovers of long-term investment prefer to use FA. In the first case, you can count on reduced commissions compared to long-term investment.
Another way to use futures is through arbitrage. Their meaning usually boils down to opening a series of related transactions aimed at making a profit due to the price difference for one type of asset at different times (time arbitrage) or in different markets (spatial arbitrage). The choice of a specific method is up to the trader.
There is a method of pair trading when a trader does not use an identical instrument, but a pair of assets that are similar in dynamics, for example, two different grades of oil from the same “producing company”. After the purchase of the first futures contract, the price change is observed, and, according to the confirmed fluctuations, the second one is purchased at a more favorable price.
Traders often look for minor discrepancies in price changes if contracts for both assets were purchased at the same time. As soon as their value “went to convergence”, the next purchase/sale transactions are carried out, proceeding from the assumption of the predominantly synchronous dynamics of both assets. The term of execution of contracts when using arbitrage operations can be any, it all depends on the preferences of the trader.