Today’s post is one that will discuss exhaustively the concept of Futures Trading.
Future Trading is an agreement to trade a specified amount of a commodity at a set price on a specified date in the future. Hence the name – Futures Trading.
This is just a tip of the iceberg!
The full analysis (what it is used for, how it works, etc) is what I discussed under the subheadings below.
Let’s go check out the subheadings.
Futures Trading Post Outline
What you will find in this part is the rundown of the subheadings that will be discussed.
The subheadings include:
- What is Futures Trading?
- How Does Futures Trading Work?
- How Do Speculators Make Money?
- Types of Futures Trading
- Risks Associated With Futures Trading
- Similarities and Differences Between Futures and Options Trading
You will also find that I added the links to the full details of each subheading.
This is for easy navigation and for a wonderful reading experience.
Now, we will get started in earnest.
What is Futures Trading?
Futures Trading or Contract is an agreement between 2 parties to buy or sell a product at a given date and price in the future.
Don’t worry, I will explain further.
Looking at the word ‘Futures’, it means something that will happen at a later time. ‘Trading’ is basically the act of buying and selling.
Simply put: Futures Trading is about buying/selling something at a later time.
For this Futures Trading/Contract to take place, there have to be 2 parties involved – a buyer and a seller.
It is these 2 that now come together and reach an agreement about the time and price at which the ‘agreement’ will be executed.
This means that the commodity agreed upon has to be traded at the agreed time and price no matter what happens.
Guess it’s a bit clearer now?
The history of Futures Trading can be traced as far back as the 17th century.
Since then, Futures Trading has been adopted by various countries to trade different markets be it Forex, cryptocurrencies, commodities, etc.
Buyers and Sellers go into Futures Trading/Contract to protect themselves from price volatility. This is known as the act of Hedging.
Hedging is a way to reduce the possibility of experiencing a loss because of a change in the market value of an underlying asset.
This way, the price is somehow kept at a fixed rate.
To ensure you fully get a grasp of how Futures Trading work, I gave an analogy in a layman’s term in the next subheading.
Scroll and read.
How Does Futures Trading Work?
To explain this simply, I will create a scenario here. I have a soft drink producing company (say Coca Cola) and a sugar producing company (St. Louis).
The manager at Coca Cola meets with that of St. Louis and strikes a deal to buy 50kg of sugar in 2months at $1.20 for 1kg.
Let’s take the current date to be 20th October. So the deal will mature in December.
There are 2 perspectives to the outcome of this deal – The Buyer’s and The Seller’s.
The Buyer’s Perspective
The buyer in this case is the Coca Cola company. The team wants to make more money by keeping the cost of production as controlled and as predictable as possible.
So they think to themselves: With things getting more expensive by the day, the price of sugar will surely rise come December. It will definitely be better if we strike a deal with St. Louis now to buy at this present price come December.
Assuming after the deal, there came a tornado that destroyed sugar farms around the city causing the price of sugar to rise to $1.70 per kg.
Even at this increased price, the Coca Cola company will still pay $1.20 as agreed.
Here, the Seller bears the loss.
The Seller’s Perspective
You will find that the Seller plans to make more money by selling as high as the Buyer is willing to pay.
In their mind, St. Louis team(Seller) will think to themselves: With Dangote and Golden Penny opening up sugar farms, the price of sugar will surely decrease as there will be more supply than demand. So, let’s just strike this deal early and make more money.
Assuming as envisioned by the St. Louis team, their competitors succeeds in setting up their farms and start selling sugar at $1 per kg. This will cause the price of sugar to drop.
But even with the drop in price, St. Louis will still receive $1.20 from Coca Cola as agreed.
So here, the Buyer loses.
This is a sample of how Futures Trading works.
But we all know everyone is not buying sugar or exchanging one product or another.
Some people are just in the market to speculate on the price movement of these products.
These people are investors or speculators and they make money through changes in price.
To bring it home to you as a crypto trader, let’s check out this next subheading.
How Do Speculators Make Money?
Some people participate in the Futures market as Speculators – either as an Investor or a Trader.
These set of people are just in the market to speculate on price movements.
They can buy and sell the futures contract with no intention of taking delivery of the underlying commodity.
With speculators, investors, hedgers, and others buying and selling daily, there is a lively and relatively liquid market for these contracts.
Futures Contract can be settled either by Physical or by Cash Settlement.
Physical Settlement is when the Seller has to deliver the underlying asset. For example, delivering 50kg of sugar to the Coca Cola company.
Cash Settlement is when the Seller pays the difference in the price instead of providing the underlying asset. For example, when the price of sugar went up to $1.50. The Seller settles the Buyer at the expiration of the deal by paying 30 cents per kg to Coca Cola.
In trading Futures, one can either open a Long(BUY) or Short(SELL) position.
In simple terms, when you open a Long position, you intend to profit from the increase in the price of the asset.
When you open a Short position, you intend to profit from the fall in price of the asset.
To clearly explain how these speculators make money, let me create another scenario.
How a Short Position Works
Bose and Ameh are crypto traders and Ameh enters a Short position agreement with Bose. The current price of BTC is $10,000.
Ameh, perceiving that the price of BTC will fall says to Bose: I will sell 1BTC to you at $10,000 in 2 weeks.
In 2 weeks, the price of BTC fell to $8,000 but the agreement is at $10,000. So Ameh buys BTC at $8,000 and sells to Bose at $10,000 making a $2,000 gain.
Or Bose can just give Ameh $2,000.
But if in 2 weeks the price of BTC rose to $12,000 but the agreement is $10,000. Ameh will buy BTC at $12,000 and sell to Bose at $10,000 making a $2,000 loss.
Or Ameh will just give Bose $2,000.
How a Long Position Works
If it is a Long Position that they agreed on, this is how it will play out. We still have the current price of BTC at $10,000.
Ameh, perceiving that the price of BTC will rise says to Bose: I will buy BTC at $10,000 from you in 2 weeks.
In 2 weeks, the price rose to $12,000 but the agreement is at $10,000. So Ameh buys 1BTC from Bose at $10,000, goes to the market, and sells it making a $2,000 gain.
Or Bose can just give Ameh $2,000.
But if in 2 weeks, the price fells to $8,000 but the agreement is $10,000. Ameh will still buy 1 BTC at $10,000 from Bose, sells it and makes $2,000 loss.
Or Ameh can just give Bose $2,000.
Here you have the breakdown of how it works.
Moving on, we will be looking at the Futures Trading categories and products.
Types of Futures Trading
There are 2 broad markets that speculators can choose from. They are:
- Commodity Futures: These include raw materials that one can see and touch. For example:
- Metals – Gold, Silver, Ore, Copper, Steel, etc
- Energy – Natural gases, Crude oil, Coal, Petrochemicals, etc
- Agricultural products – Corn, Sugar, Cotton, Wheat, Coffee, Cows, Hogs, etc
- Financial Futures: Examples include:
- Indices (S&P 500), Nasdaq 100, etc
- Interest rate and Treasuries
- Cryptocurrencies, etc.
Depending on the speculator’s preference, Futures can be traded either traditionally or as a Perpetual Contract.
When I say ‘traditionally’, I mean the normal way Futures is traded: Agree on a specific price and date then close contract by selling or buying goods according to what the contract stipulates.
For Perpetual Contract, it is a different ball game all together. Here, instead of settling a contract within a given time(6 months, 1 year, etc), an expiry date is not even set at all.
In other words, this type of contract does not expire – it lasts a lifetime.
Points to Note When Taking Perpetual Contracts
- Mark Price(MP): This is the price at which the Perpetual Contract will be valued during trading hours. The MP is used to calculate Profit and Loss for traders. That way, market manipulations are avoided.
- Funding: This refers to the fee paid by one side of the contract to the other. For example, Long traders paying the Short traders and vice versa. The Funding Rate is set to determine which side will be the Payer and which will be the Payee. If positive, Long pays Short but when negative, Short pays Long.
- Margins: In trading Futures, the Traders should take note of the Initial and Maintenance Margins. The Maintenance Margin is the minimum amount of equity that an investor must maintain in the margin account after the purchase has been made. It is advised that traders should keep their positions above the Maintenance Margin. This is to avoid higher fees and auto liquidation.
- Risk Involved: Traders should be aware of the risk involved as Futures trading allows you to do Margin Trading. As the markets have increased, so has the available margin.
Talking about risks, Leverage/Margin Trading is not the only risk Futures traders face.
In the next subheading, I talked about the other risks one might encounter when trading Futures.
Scroll down and read up.
Risks Associated With Futures Trading
The risks a Futures trader stand to face while trading include:
1. Leverage Risks
As I mentioned earlier, leverage is one of the challenges Futures traders face.
Depending on the ratio of your initial margin, Futures trading can give you anything between 5X to 100X leverage.
Imagine earning when trading a 100X leverage….Such a good feeling!
But the thing with leverage is that it is a double-edged sword that cuts both ways.
You win when the price of the underlying asset moves in your favour but make leveraged losses when it is against you.
Imagine paying $10 in an initial margin towards a $100 asset with a 10X leverage and the price of that asset goes down by $10.
You will instantly make a 100% loss on your initial margin while the price of the underlying asset has moved down only 10%.
To mitigate this, the art of Position Sizing is used.
**Position Sizing is a way of knowing how many futures contracts you are to trade in order to ensure that when the price of the underlying asset moves against you in the amount that you expect, the total loss on the overall Futures position will still be within your risk tolerance.
2. Daily Settlement
When trading Futures, profit and losses are settled at the end of each trading day.
In trading generally, this is meant to serve as risk control which prevents losses from building up.
But in Futures, it appears to be detrimental in that you might find a position that will become profitable eventually getting closed prematuredly because of losses.
To overcome this, one needs to have enough cash to back up each position. This will cover up for any temporarily price fluctuations.
3. Policy Risk
Policies guiding Futures Trading are constantly undergoing changes and adjustments.
If not in the know about it, it might adversely affect your position.
You can remedy this by keeping yourself abreast with the latest information concerning the regulations.
4. Currency Risk
You face risk between the currency you are investing and your home currency.
If the currency you invested drops strongly against your home currency, your profit will be greatly affected.
5. Brokerage Risks
You encounter this risk when the Futures platform you are trading with suddenly fold and makes away with your money.
To avoid this, you have to ensure that you trade with reputable Futures platforms that are registered with FDIC.
It may be a little bit expensive but you are sure of the safety of your funds.
For a list of reputable platforms where you can trade Futures, check out this post.
6. Industrial Risk
Risks associated with a chosen industry can affect you as a trader.
For example, when trading crude oil, you are exposed not only to the global risk but also risks specific to the oil market.
This can be mitigated by diversifying in multiple markets.
7. Systemic Risks
This is when you have the risk of the overall market trending against you.
This happens in such a way that no matter the specific Futures contract you choose and how stable you think the market is, you still see it moving against you.
For example, when going long on a particular market, you find the supposedly stable position going bearish due to one reason or the other.
You can mitigate this by trading Futures Arbitrage.
8. Trade-Related Risks
This has to do with the trader making the correct Futures trading decisions.
This includes your ability to carry out accurate trend and price analysis as well as the right strategy to use.
There’s also the risk of Slippage where your broker fills your order at a price higher than what you decided.
This can be remedied by taking out time to study the market and be careful when setting up your orders.
9. Unlimited Liability
Sometimes while trading Futures, your losses may accumulate beyond you committed capital.
This can be because the price of the underlying asset continues to move against your Futures position.
These losses that you incur are deducted from your initial capital. If it is so much of a loss, you might lose all your funds.
To avoid this, you have to put a strict Stop Loss and Risk Management Policy in place when trading Futures.
Here you have the risks associated with Futures Trading listed.
Now you might be thinking: Is Futures Trading not just like Options Trading? Are they not just one and the same thing?
I answered that question below. Let’s check it out below.
Similarities and Differences Between Futures and Options Trading
Both Futures and Options trading are alike in the sense that they are Derivatives; they derive their values from an underlying asset.
They both create hedging opportunities for traders.
In as much as they are similar, their applications are totally different.
- Futures Contract creates an obligation to buy/sell something at a future date. For Options, you only get the right(not under any obligation) to buy/sell something at a future date.
- For the execution of the trades, a Futures Contract is executed on a pre-agreed date while an Options trade has to be carried out at any date prior to its expiry.
- To start up, Options requires that you deposit a premium for the right to the end result. But for Futures, you will just make a small down payment for the end result.
- The last way they differ is in their level of risk. The risk is more when trading Futures but quite low when you are working with Options. The highest loss you can incur is the premium you paid.
Here you have the similarities and dissimilarities of Futures and Options.
Let’s get on to the concluding part.
Here is the last part of today’s post. Hope you had a great reading experience?
I also know you must have learnt a great deal about Futures and how it works.
Spare me a few more minutes and help to answer these questions below.
Have you traded Futures before? What was your experience?
In your opinion, which is riskier – Futures or Options?
While trading Futures, which will/do you prefer – Cash or Physical settlement?
Or maybe you still have questions regarding the post.
Just leave me your answers and questions (if any) in the comment box below.
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Other related articles include:
- Top Futures Trading Platforms: The Complete List
- Options Trading: What Is It All About?
- Crypto Trading Explained: A Concise Beginner’s Guide