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An Introduction to Futures Trading, and How it work

4 Mins read

Futures trading is a popular method of trading in financial markets, allowing traders to speculate on the future price movements of assets. In this article, we will explore the fundamentals of futures trading, how it works, its benefits, and the associated risks.

What is Futures Trading?

Futures trading involves buying and selling futures contracts, which are standardized legal agreements to buy or sell an asset at a predetermined price at a specified time in the future. In simple terms, Futures are contracts to buy or sell a specific asset at a future date. These contracts are traded on futures exchanges and can be based on various underlying assets, including commodities, stocks, indices, and cryptocurrencies.

NB: The buyer of a futures contract must take possession of the underlying stocks or shares at the time of expiration and not before. Buyers of futures contracts may sell their positions before expiration.

How Does Futures Trading Work?

  1. Futures Contracts: A futures contract specifies the quantity of the underlying asset, the price at which it will be bought or sold, and the delivery date. These contracts are standardized, meaning they have fixed terms and conditions set by the exchange.
  2. Leverage: Futures trading typically involves leverage, allowing traders to control a large position with a relatively small amount of capital. This can amplify both potential gains and potential losses.
  3. Margin Requirements: Traders are required to deposit an initial margin, a percentage of the contract’s value, to open a futures position. They must also maintain a minimum margin level to keep the position open.
  4. Settlement: Futures contracts can be settled in two ways: physical delivery or cash settlement. In physical delivery, the actual asset is delivered at the contract’s expiration. In cash settlement, the difference between the contract price and the market price is settled in cash.
  5. Hedging and Speculation: Futures contracts are used for hedging, allowing businesses to lock in prices for commodities or inputs, and for speculation, where traders aim to profit from price movements.

Benefits of Futures Trading

  1. Leverage: Futures trading allows traders to control large positions with a small amount of capital, potentially increasing returns on investment.
  2. Liquidity: Futures markets are highly liquid, with many buyers and sellers, ensuring that positions can be entered and exited easily.
  3. Diversification: Futures trading offers exposure to a wide range of assets, including commodities, indices, and cryptocurrencies, helping traders diversify their portfolios.
  4. Hedging: Businesses and investors can use futures contracts to hedge against price fluctuations, reducing risk and ensuring price stability for their operations.
  5. Transparency and Regulation: Futures markets are regulated and operate with a high degree of transparency, providing traders with a fair and secure trading environment.

Real Life Scenario

To illustrate how this works in real life, let’s follow the journey of Isaac, a retail trader, as he navigates the world of futures trading.

Background

Isaac is an experienced trader who has primarily dealt with stocks and cryptocurrencies. He recently decided to diversify his portfolio by venturing into futures trading. After conducting thorough research, He opens a margin account with OctaFX a reputable brokerage, and deposits $10,000.

Choosing an Asset

Isaac is particularly interested in crude oil futures due to its volatility and significant price movements. He believes that the price of crude oil will increase over the next few months due to anticipated production cuts by major oil-producing countries.

Opening a Position

Isaac decides to buy a crude oil futures contract. Each crude oil futures contract on OctaFX his chosen exchange represents 1,000 barrels of oil. At the time of his decision, the price of crude oil is $50 per barrel. The total value of the contract is $50,000 (1,000 barrels * $50 per barrel).

Using leverage, Isaac is only required to put up a fraction of the contract’s value as margin. With a margin requirement of 10%, he needs to deposit $5,000 to open his position.

Monitoring the Market

Isaac closely monitors market news, geopolitical events, and economic reports that could impact oil prices. He uses technical analysis to identify potential entry and exit points. Over the next few weeks, oil prices start to rise due to supply concerns and increased demand.

Closing the Position

Two months later, the price of crude oil has risen to $60 per barrel. Isaac decides it’s time to close his position and lock in his profits. The new value of his futures contract is $60,000 (1,000 barrels * $60 per barrel).

Calculating the Profit

Isaac’s profit is the difference between the selling price and the buying price, multiplied by the number of barrels in the contract:

Profit = (60 – 50) * 1,000 = $10,000

After closing the position, He pays the broker’s commission and any other fees, but his net profit remains substantial.

Risks and Challenges

While Isaac’s trade was successful, it’s important to highlight the risks involved in futures trading:

  • Leverage Risk: While leverage can amplify gains, it can also magnify losses. Traders can lose more than their initial investment if the market moves against their position. For example, If the price of crude oil had fallen instead, Isaac could have faced significant losses, potentially exceeding his initial margin.
  • Market Volatility: Futures markets can be highly volatile, and sudden price swings can result in rapid changes in account equity.
  • Margin Calls: If the value of a trader’s position falls below the maintenance margin level, they will receive a margin call, requiring them to deposit additional funds or close the position. For example, If the market moved against Isaac’s position, He would have received a margin call, requiring him to deposit additional funds to maintain her position.
  • Complexity: Futures trading involves complex concepts and requires a deep understanding of market dynamics, making it challenging for inexperienced traders. Isaac has a deep understanding of the Oil market and he stuck with it.
  • Liquidity Risk: While futures markets are generally liquid, some contracts may have lower liquidity, making it difficult to enter or exit positions without affecting the price.

Popular Futures Trading Platforms

  1. Chicago Mercantile Exchange (CME): One of the largest futures exchanges in the world, offering a wide range of futures contracts on commodities, indices, and currencies.
  2. Intercontinental Exchange (ICE): A global exchange that provides futures and options contracts on commodities, energy products, and financial instruments.
  3. Cryptocurrency Exchanges: Cryptocurrency CEXs such as BinanceOKXBybitBitget, and BingX offer futures trading on various digital assets with high-leverage options.
  4. TD Ameritrade: A well-known brokerage that provides futures trading on commodities, indices, and interest rates, along with educational resources for traders.

Conclusion

Futures trading is a dynamic and potentially lucrative form of trading that allows participants to speculate on the future price movements of various assets.  Futures trading can be a profitable venture for knowledgeable and disciplined traders like Isaac. However, it comes with significant risks that require careful management. Traders must conduct thorough research, stay informed about market conditions, and use effective risk management strategies to succeed in the futures market.

For further reading and updates, visit Investopedia

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There's this unexplainable joy I get whenever I write, knowing fully well that my copy will transform people's life and destiny. This rare feeling elates me and encourages me to write more value-packed pieces. I think a divine being has possessed me to write, that is why I write, Therefore, I will advise every of my piece should be regarded as a divine message.
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