Futures Trading - Introduction
Futures trading is the trading of futures contracts which allows specific stocks, commoditites or such assets to be traded at a pre-determined price in future. For instance, a farmer may short a futures contract on his 5000 bushels of corn grains at the price of $0.30 per bushel to a buyer of corn grains. By doing so, the farmer has guaranteed himself the price of $0.30 per bushel for his corns when harvest time comes. The buyer would also have guaranteed himself the purchase price of $0.30 per bushel. In this case, the farmer is clearly hedging against a drop in price of corns while the buyer is clearly expecting the price of corn to be higher than $0.30 when harvest time comes and commits himself to buying at that price. Of course, this is merely an over simplified example of how futures work.
Why Futures Trading?
The above example outlined a classic use of futures in commodities trading, also known as commodities futures trading. Indeed, Futures are derivatives instruments that derive their value from their underlying assets and their main function is to help buyers and sellers of the underlying asset go into purchase agreements that protect against price fluctuations. To date, this remains the most important function of futures trading.
However, apart from being a great hedging tool like it is meant to be, futures trading also opened the door to leveraged speculation of price fluctuations and have created many a lucky stock market millionaire. In fact, with the creation of Single Stock Futures (SSF) in 2002 in the US market by the CBOE, futures trading now extends to stocks of listed companies as the underlying asset, providing participants in the capital market with another avenue of leveraged trading.
Yes, leverage is another reason that makes futures trading so powerful and dangerous.
Futures trading has leverage due to the fact that only a small deposit, known as the initial margin, is needed to control a large amount of underlying asset. Using our corn farmer example above, the buyer of the futures contract on his corns only need pay the farmer a small deposit of maybe only $150 to guarantee the purchase of 5000 bushels of corn at $0.30 per bushel worth $1500 (the "Futures Price") in all. So, instead of paying $1500 to control the price on 5000 bushels of corn at $0.30, the futures buyer paid only $150 to do the same thing. Thats a 10 times leverage on his money.
If the price of corn in this example should suddenly surge to $1 per bushel due to a poor harvest, the buyer of the futures contract would still be able to buy the corn from the farmer for only $0.30 per bushel, and sell those corn in the market for $1.00 per bushel, making a total of $3500 out of a $150 capital commitment. Yes, a 2300% profit! That's the leverage power of futures trading.
4 Main Types of Futures Traders
There are 4 main types of futures traders in the futures market, creating the liquid futures trading environment that we see today. No matter what you choose to do in futures trading, you will inevitably fall in one or more of these types. The 4 types of futures traders are really classified based on the purpose of their trades rather than the actual trading strategies itself as the same futures strategy can be applied for various purposes. The 4 types of futures traders in the futures trading market are; Hedgers, Speculators, Arbitrageurs and Spreaders.
Hedgers
Hedgers do with futures contracts what futures contracts were initially designed to do when it was first developed along the rivers of Chicago (read the History of Futures Trading), which is to hedge against price risk. You are a hedger when you are go short on futures contracts while owning the underlying asset or other futures contracts of the same or related underlying in order to protect your existing positions against price fluctuations.
Speculators
Speculators form the backbone of the futures trading market we see today. They provide liquidity and activity in the futures trading market through their day trading or swing trading strategies, buying and selling futures contracts outright in order to speculate on a strong directional move. This is also the most dangerous way of trading futures as the price of the underlying asset could just as easily come around and put your position in a loss deep enough for a margin call.
Learn the Steps In Trading Futures for speculation.
Arbitrageurs
Arbitrageurs are futures traders that are in the market in order to spot price anormalies between futures contracts and their underlying assets in order to reap a risk free return. Arbitrage is another huge source of volume and liquidity in the market as it typically takes an extremely big fund and big trading volume in order to return a worthwhile profit in arbitrage. Arbitrage is such a competitive area right now that super computers with powerful programs to spot such opportunities are set to perform such arbitrage automatically.
Learn more about Futures Arbitrage.
Spreaders
Spreaders are futures traders that specialises in trading futures contracts in combination with other futures contracts or underlying in order to reduce risk and to extend profitability. Such complex futures positions are what is known as "Futures Spreads" or "Futures Strategies". This is a very professional and specialised field that has only recently been made known to the general public and makes use of the difference in price and rate of change in price of different offsetting futures contracts in order to create futures positions that move within certain limits and have a much higher chance of profit with a lot lower commissions. Read all about Futures Spreads.
Danger of Futures Trading
Futures traders who buy futures contracts purely for leveraged speculation frequently lose more money than what they put in when prices move against them, triggering margin calls that requires additional top up of money in order to keep the contract alive or be forcefully closed out. Yes, many a multi-million corporations have gone bankrupt due to abuse of futures trading. Too many futures traders have abused the leverage of futures trading by buying futures contracts with almost all their money, expecting prices to go straight up without keeping a reasonable reserve to serve margin calls for those short term price fluctuations. These futures traders frequently lose all their money and more, casting a shadow on futures trading, making futures more dangerous than it really is.
