The Basics of Futures Trading

Futures is a standardized forward contract which can be easily traded between parties other than the two initial parties to the contract.

The Age of Technology

Supercomputers, internet, robots, tablets, and complex software applications are not the only things to celebrate about the human genius.

Unfortunately, it is only these that humans appreciate, forgetting marvelous works that writers and musicians do to words, the complex developments in law, art, medicine, and the rest.

The most spectacular field however is business, and this is because it encompasses all the above areas, plus unmentioned others.

There are many areas and people to heap praises on. But because this article is about futures trade, it is appropriate that we narrow it down to the most relevant things. First, let’s travel back in time…

Chicago in 1840

You are in Chicago in 1840. It is likely that you are a stranger here; you migrated to this place only one or two years ago to escape potato famine, which is currently wiping out the population of Ireland- your motherland.

You have already established yourself in business. Early morning tomorrow, you are going to wait along the railway line to get the best deal out of the wheat suppliers that are coming in from the Midwest.

You hope to buy 100 bushels at 80 cents each. This will enable you to get a profit of $1 when you sell your stock at 81 cents per bushel.

Unfortunately, when wheat comes in the next day, the cunning Midwestern suppliers insist that their going price per bushel is 82 cents- no bargains. So after a few grunts, you give in.

This means you have to take in less stock than you anticipated in your budget- 97 bushels to be precise. You will also have to raise your selling price from the earlier projections of 81 cents per bushel to avoid losses.

But one day a good idea strikes: what if you could find a Midwestern supplier and pay him in advance so that he can bring 100 bushels to you next month at today’s market rate?

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Okay, because of trust issues, paying a full upfront amount wouldn’t be a good idea; but you can make a pledge and give them a small deposit, with a promise to make the remaining payments once the goods are delivered.

That’s it! You have just discovered (or should we say invented?) trading futures. Soon, copycats are going to get wind of the idea and apply it as it is, or combine it with other copied ideas to make it more advanced and efficient.

Trading Futures Today

Today’s futures trade is highly complex. However, the entire concept is based on the small idea that some uncelebrated businessman (or woman) in the 1840s Chicago came up with.

With the rapid advancement in internet technology, futures trade has grown to giant levels, becoming one of the prime anchors of the global economy.

Once a preserve for long-life goods like cereals and other dry foods, today’s futures market also includes short life commodities like milk, juice, meat, and vegetables among others. In addition, high value items like gold have also been incorporated into the futures market.

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The Ultimate Way to Guarantee a Price

From the previous example, you notice one obvious benefit of futures trade: it minimizes price fluctuations and assures the buyer that he or she will acquire an item at a particular price in the  future, and therefore facilitates budgeting.

However, today’s futures contract holder does not have to buy the items in question; some active stock market participants have never even seen a pig eye to eye, yet they have been dealing with pork futures for decades! How is that possible?

How it Works

The theoretical assumption when you acquire a futures contract is that you will buy the underlying goods at the end of contract period. This however is not how it happens in the end; you don’t have any market channels and if the goods were to be put in your hands, you would not have a way of selling them.

Therefore, assuming the prices of the goods in question appreciate, the producers will not sell them directly to you; rather, they will use their own marketing channels to dispose of the goods.

After the goods are sold, the producer will then subtract the earlier agreed buying price (the price at which you agreed to buy the goods on maturity) and any additional costs incurred in getting the goods to market, and give the remaining money to the futures contract owner. The producer will also return the upfront payment (margin) to your account.

Liquidity

The futures market is highly liquid. These contracts are regarded as exchange instruments, based on the expected future value of the underlying goods and the margin. In other words, you can sell one futures contract at any time of your choice before expiry, and buy another when you like.

It is however preferable to sell a futures contract just before its expiry, as it is during this time that you are likely to get the fairest buyer. On the other hand, buying a futures contract early is the advisable thing because prices tend to be lower at that time.

Keeping your futures contract for sale at maturity date neither guarantees you a profit nor loss. If the price of the underlying item moves up, you will earn a profit; if it goes down, you lose the margin. You might also be required to make additional payments to cover for the fall in price.

Margin = Insurance

A margin is not a deposit per se, because it is returned to the futures contract buyer if the market moves in their favor. However, if things move the other way, the margin serves as insurance, and the supplier can demand for more money if market prices continue to fall while the futures contract is still intact.

Futures contract buyers however have the freedom to terminate the agreement at any time, and therefore only cover for the losses up to the time of termination.

Trading Futures Online

If you have enough capital to meet the margin requirements and broker fees, you can start trading futures online. The required margin always varies depending on the underlying goods and the trading approach that you take.

There are two main approaches to futures trading: the normal approach and the spread betting approach.

Spread Betting

Spread betting is not legal in the USA, but is acceptable in Europe. Under this approach, a trader places bets on whether the price of a commodity will fall or rise. If they think that prices will rise, they place an “up bet”. If they believe that prices will fall, they place a “down bet”.

If a person places an up bet and the prices rise, they earn cash for every price movement. The same happens if one places a down bet and prices fall.

However, if prices fall when an investor had predicted a rise, he or she loses an agreed amount of money for every downward price movement. The same happens when one predicts a fall and prices rise instead.

Normal Futures Trading

Spread betting is just a recent derivative of futures trade. The normal futures trade is the one that has been described in most part of this article. It is accepted in both the US and Europe.

Generally, people with high capital endowments are the most likely to survive in this trade. This is because they are able to expand their portfolio by investing in different futures trade items, thereby spreading risks.

Before you start engaging in future trades, it is important that you train first. A demo account allows you to practice in the current market without incurring risks. Try out a futures demo account today.