A futures contract is always linked to an actual asset. It functions as an obligatory transaction at a predetermined date and is a derivate of the underlying asset. This means that there are two underlying principles that define the trade contract:
- The buyer must buy the asset at the set date and price.
- The seller must sell the asset at the set date and price.
One core goal of any broker that trades financial instruments such as futures contracts is risk mitigation. Both contract parties put up an initial sum called a "margin" that must be maintained over the futures contract's time period. Trading using futures goes back to the 17th century when traders sold contracts on tulips. This historic role model defined futures types for centuries, and even today, commodity futures, e.g., for crude oil, gold, silver, or corn, are an essential part of trade futures markets. Other common types are:
- index futures
- currency futures
- interest rate futures
- stock futures
Traders are allowed to individually set the parameters for a futures contract which is why some brokers are trading futures contracts for very exotic goods or commodities.
Let's look at an example of how options work: A broker on a trading platform negotiates a call option to buy a stock at a set strike price of $50. He can buy the said stock at the negotiated price for the next three months. If the stock price goes up to 75$, he can immediately pay his strike price and resell the stock on a trading platform to net a profit of $25. But crucially, if the price drops below the $50 strike price, the trader isn't obligated to buy.
A brokerage can use both instruments – options and trade futures – for speculating or hedging in order to yield financial gains. On a cursory look, both types have a lot in common as they are both derivates of an underlying asset. Derivative holders like brokers or brokerages don't actually own the asset, though. As a strategy, brokers can use both derivates in day trading to benefit from price fluctuation. But there is one key difference between trading futures and options:
Options give a broker the right to buy or sell a share at a set price at any given point in time. Futures traders are obliged to buy or sell shares at a specific date in the future.
Let's look at an example how options work: A broker on a trading platform negotiates a call option to buy a stock at a set strike price of $50. For the next three months, he can buy said stock at the negotiated price. If the stock price goes up to 75$, he can immediately pay his strike price and resell the stock on a trading platform to net a profit of $25. But crucially, if the price drops below the $50 strike price, the trader isn't obligated to buy.
Futures traders usually belong to one of two categories: "hedgers" or "speculators". The former are traders who seek to maximize their assets' value while also reducing the potential loss that price changes can cause. The latter are those traders that are looking to profit from price changes. Both types operate in various investment areas, i.e., futures markets like the ICE, the Chicago Mercantile Exchange, or Eurex.
A professional futures market is usually registered with the CFTC – the Commodity Futures Trading Commission. This is the agency responsible for regulating futures markets in the U.S.
Speculators seek to make a profit off of a commodity's price increase. This is the case if two things happen: the commodity has gotten more valuable, and it is trading at a higher rate than the original futures price. The investor then unwinds or offsets the buy trade – before the trading future expires – at the current high price. The difference between the original and current price is the yielded profit.
Turning this principle on its head, speculators can also yield gains by betting on an asset dropping in value. To do this, they have to position themselves in an offsetting position. The contract then closes, and the net difference between the higher futures contract price and the lower current price turns into profit for the speculator. Both investment strategies are relatively risky, though, as both losses and gains can be amplified due to the derivate type's nature.
A strategy of speculating on margin requirements, i.e., margins themselves, comes attached with even greater risk. Potential losses can far exceed a retail investor's funds which is why non-professional speculators should shy away from these investments.
Trading futures contracts for hedging is another strategy. It's applied to guarantee a set price if an investor expects unfavorable price fluctuation. One historical example for this are corn farmers:
Historically, trading commodities like corn with futures was a viable way to guarantee a certain value for a set amount of crops. A farmer opens up a trading future to lock in money for his crops. He'd then be able to yield a gain trading his hedging future despite selling the real crops at a decreased value. The gain on the former offsets the loss of the latter – and the farmer still hits an acceptable price on the market for his crops.
Trading in futures means operating in a volatile environment. Due to the details of how futures contracts work, traders must be able to handle the risk of potentially losing more than they have paid in the initial margin. Also, the margin is ambiguous since it may amplify gains, but it can also magnify losses, especially when circumventing futures trading and speculating on margins itself.
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