Futures trading is a type of derivative trading that allows investors to speculate on the movement of stock markets and potentially benefit from price changes of stock markets without purchasing the stocks. As a contract, investors are obligated to buy or sell a stock index at the predetermined future date and price that they had agreed to with the contract seller.
This article will guide you through what futures trading is, how it works, and some advantages and risks of using futures trading to trade stock indices.
Understanding the basics of futures
Before diving into strategies and looking for indices to trade, it’s crucial to grasp the fundamentals of futures. A future is a type of derivative contract that obligates the holder to buy or sell a stock at a predetermined future date and price. Investors use future contracts to speculate on price movements of stock indices that may take place in the future, hoping to get a better deal on the trade when the time comes.
Futures can take on more than just stocks as underlying assets. They are frequently used on physical commodity trading, such as instruments within the energy market like oil and gas. They can also be used to speculate on bonds, currencies, and other financial securities. Futures are traded by many different types of traders – from retail investors to institutional and professional traders and large corporations.
Traders trade futures contracts on a futures exchange, and a contract’s price settles after the end of every trading session. These exchanges are organised and transparent, and they are a preference for many traders.
How futures trading works
In essence, futures contracts are investment vehicles that allow traders to ‘lock in’ the price of the underlying asset the trader wishes to speculate on. These contracts have expiration dates in the form of months – for example December, January, February, and they have set prices that are agreed to by the buyer and the seller upfront.
When a buyer purchases a futures contract, they are obligated to take possession of the underlying asset at the time of expiration. They can buy or sell at any time before the expiration date and be free from their contract.
Futures contracts can be cash-settled in the investor’s brokerage account, with the difference between the current and predetermined price being the profit or the loss.
Using futures to speculate on market movements
Futures can be used to speculate on market movements of indices. A stock index is a benchmark of a group of stocks with a shared trait – for example, the ASX 200 tracks the Top 200 performing stocks in the Australian stock market by market capitalisation.
When a trader purchases a future contract to speculate on the direction of the index, and the price of the index rises and begins to trade above the original price at expiration, then the trader would have made a profit. This is because the trader would be able to sell the contract at the current price and close the position before expiration. In the opposite event, the trader would suffer a loss.
Traders of futures can trade on margin – or use leverage in their positions. This means they can take a much larger position than the amount of funds they have in their brokerage account. Margin investing is a double-edged sword – as it can amplify gains by a large amount or it can magnify losses beyond the trader’s original account balance.
Advantages and risk of speculative futures trading
There are different advantages and disadvantages of futures trading, regardless of the underlying asset upon which is being speculated. Let’s explore them below.
Advantages of speculative futures trading
One of the biggest advantages of futures trading is that traders can lock in the price of an asset before they reach a certain date. This allows them to – if they can more or less predict market movements – potentially receive returns.
Futures contracts can also be traded on margin – or with leverage. This allows traders to take a much larger position in the market than they otherwise would be able to from the offset, based on only their existing funds in their account. The fact that traders only need a deposit that is a fraction of the contract amount can make a big difference in potential profits.
Risk of speculative futures trading
Nevertheless, futures trading contains risks. With the use of leverage, investors may risk losing more than their initial margin amount. This can eat into their existing funds in their account as well, leaving them destitute. This can be mitigated by having a careful trading strategy and plan and understanding the level of risk that one can take as a trader.
Summary
Futures trading can be a good way to lock in prices early when traders anticipate substantial market movement in either direction. Futures trading can be done through the purchase of a futures contract, which is an investment vehicle that allows traders to speculate on an asset such as a stock index, a commodity, a bond, a currency pair, or other instruments. They are traded on a centralised exchange, and they have a relatively high level of transparency, which is favoured by many traders.
Though futures trading can potentially bring great returns, it is essential to remember that they may also cause great losses should the markets not move in your favoured and predicted direction. Therefore, always trade with caution and never trade with more money than you can afford to lose.
