Futures & futures trading: everything you need to know
Trading futures: how they work, risks – including hedging, opportunities and how to access them. Discover more on Fineco Newsroom.
IN A FEW WORDS
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7 min reading
Focus on futures: trading and investing
Trading or investing futures lets you speculate on the future price of assets or stock markets. Using futures contracts, trading on exchanges or investing in futures funds can offer liquidity and potential for leveraging and hedging.
Originally used to reduce uncertainty around the future price of crops and other commodities, futures have become a widely used trading instrument. They now offer a means to speculate on everything from the price of oil to Amazon’s share price.
The basics of futures trading and how it works
A futures contract is a legal agreement to buy or sell a specific asset at a set date in the future (the delivery date) and for a predetermined price (the forward price). Futures are a derivative – they depend on the performance of an underlying asset but are not the asset themselves.
Given that the buyer of a futures contract has an obligation to take receipt of the asset when the contract expires (and the seller has an obligation to deliver it), most traders will buy or sell contracts to offload their exposure. The two contracts will be netted off (the selling price less the cost to give a profit or loss) and the trader receives a cash settlement. After all, few traders want to take delivery of 50 barrels of oil at their home.
Futures are traded on an exchange, which brings several advantages
First, they conform to specific standards for quality and quantity, which may not be the case if simply negotiated between two parties. Second, they are liquid; pricing is transparent, and costs are relatively low. It is also possible to achieve leverage through futures trading. Brokers will often only require a fraction of the contract value as a deposit, allowing investors to get significant exposure for a relatively small outlay. There is also less counterparty risk because the exchange will only deal with reputable counterparties. However, futures are commoditised. That means traders have to use established contracts. This separates them from, for example, contracts for differences, where the price is negotiated between two parties.
Forwards look a lot like futures but are traded over-the-counter (OTC) rather than on an exchange. As such, it is possible for the buyer and seller to agree bespoke terms. Futures contracts have the same terms regardless of the counterparty.
Traders can speculate on price movements of single assets or use market futures
Futures are usually used to speculate on price movements in a specific instrument, such as shares, commodities, interest rates, indices or a range of other financial assets. In practice, if the trader buys a futures contract on the price of gold, for example, and the gold price rises, they have a profit. Before the contract expires and they have to take delivery of 1,000 gold bars, the original trade is offset with a sell trade for the same amount of gold at the current market price. This nets off the original position and any profit (or loss) will be reflected in a trader’s brokerage account.
Futures are also a useful tool for hedging, a means of managing risk in case of adverse pricing movements. For example, if an investor with a portfolio of shares believes an event may disrupt the stock market in the short-term (such as a natural disaster or a political event), they can buy a future on the S&P 500 to hedge the risk that their portfolio will experience short-term losses. They use futures to go ‘short’ on the S&P 500 (positioning for a fall in price), and the profits made on the trade help compensate for any losses in their main portfolio. Using a US stock future, also known as an index future, in this way prevents them having to liquidate their portfolio, with all the costs that may entail.
Pricing a future depends on a range of considerations
The price of a future depends on the price of the underlying asset, the so called ‘risk free rate’ (a function of interest rates) and the length of the contract, plus some peripheral considerations such as storage costs (for commodity futures) or dividend yields (for stock market futures).
For example, a bread producer in early August 2021 knows they will need 100 tonnes of wheat in six months’ time. They know the current price of wheat at that point is around $7.10 per bushel but also that wheat prices are influenced by the weather. They don’t want to pay significantly more in six months’ time and so lock in a price using commodities futures. Potentially, they could have paid less, but at least they can manage their costs.
Futures funds are one way of investing in futures
It is possible to buy a futures fund, where an experienced fund manager will put together a portfolio of stock market or index futures, commodity futures, fixed income or currency futures. The fund could act as a diversifier to a standard equity and bond portfolio. It is a way to invest in the futures market without having to trade. The Fineco platform lets you trade or invest in a range of futures markets, including leveraged options at low prices.
Information or views expressed should not be taken as any kind of recommendation or forecast. All trading involves risks, losses can exceed deposits.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 64.14% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Before trading CFDs, please read carefully the Key Information Documents (KIDs) available on the website finecobank.co.uk
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