Futures trading is a dynamic and widely practised form of financial investment that revolves around the buying and selling of derivative contracts known as futures. At its core, a futures contract is an agreement between two parties to buy or sell a specific underlying asset at a predetermined price on a future date. Read on to know more.
What is Futures Trading?
Defining Futures Trading
Derivatives derive their value from the price movements of other financial instruments. Futures, a type of derivative contract. Futures trading meaning is, thus, one where:
- There is a purchase or sale of an asset on a future date at a predetermined price.
- This asset can range from company shares to commodities like coffee, silver, or gold.
- Futures trading in the stock market refers to the buying and selling of futures contracts that are based on specific stocks or stock market indexes.
- A buyer (long position) and a seller (short position) agree to buy and provide the asset, respectively.
- These contracts are traded on exchanges.
- Over time, the contract’s price changes based on the underlying asset, resulting in potential profits or losses for traders.
- There are obligatory agreements where buyers and sellers must honour the contract terms.
Pros and Cons
Like any trading method, futures trading has advantages and disadvantages.
- Leverage: Futures allow for larger positions with a small initial investment, increasing potential returns. However, losses can exceed the initial margin.
- Diversification: One can trade futures on various assets, providing a diversified portfolio across different classes.
- After-Hours Trading: One can exploit opportunities beyond regular market hours.
- Hedging: It protects profits or minimises losses by hedging against market or commodity risks.
- Complexity: Futures trading involves complexities and requires time, effort, and market monitoring.
- Over-Leverage: Leverage amplifies both gains and losses, exposing traders to significant risks.
- Managing Expiry Dates: Monitoring and rolling forward contracts before expiry is essential to avoid value loss.
- Physical Delivery: Failure to close positions may result in taking physical delivery of the underlying asset, requiring payment at the agreed-upon price.
How Does Futures Trading Work?
Futures trading serves different purposes, primarily hedging against commodity price fluctuations or capitalising on price movements. Futures contracts cover various assets like stocks, indices, currency pairs, and commodities.
The two main participants who engage in futures trading are hedgers and speculators.
- Hedgers, often businesses or individuals involved in the underlying cash commodity, use futures to protect against unpredictable price shifts. For example, a food processor may hedge against rising corn prices by buying enough corn futures contracts to offset potential losses in cash corn purchases.
- Speculators include independent floor traders who trade for their accounts and investors. Speculators aim to profit from anticipated price movements in futures contracts, independent of their direct involvement in the underlying commodity.
The Working Process
Futures trading operates through a standardised process that involves buying and selling futures contracts on various exchanges. Here’s a step-by-step explanation of how futures trading works:
- Understanding the Market: Analyse market conditions, research, and identify potential opportunities.
- Placing Orders: Use an approved brokerage account to place buy or sell orders for futures contracts.
- Margin Requirement: Deposit a fraction of the contract value as collateral to cover potential losses.
- Price Fluctuations: Futures contract prices fluctuate based on supply and demand, economic indicators, and market sentiment.
- Profit and Loss: Monitor price movements and close positions to secure profits or manage losses.
- Contract Expiration: Close positions before expiration to avoid physical delivery of the underlying asset.
- Settling the Trade: Contracts are settled through physical delivery or cash settlement.
- Risk Management: Implement strategies like stop-loss orders, portfolio diversification, and position size management to mitigate risks.
How to Start Futures Trading
Starting futures trading requires careful preparation and a step-by-step approach to ensure success. Here’s how to begin futures trading:
- Learn: Gain a comprehensive understanding of futures trading concepts, terminology, and market dynamics through reputable educational resources and materials.
- Know Your Objectives: Define your objectives and preferred trading style. This includes risk tolerance, capital allocation, and investment horizon to shape your trading plan.
- Choose a Reputable Brokerage or a Platform: Choose a reputable brokerage with futures trading services, considering factors like commission rates, trading platforms, support, research tools, and education. Ensure it’s regulated, user-friendly, and offers intuitive interfaces, diverse order types, and competitive fees. Nowadays, trading can happen on online platforms as well. uTrade Algos is one such platform that active traders often use since it allows for mobile trading and is very convenient to use as well.
- Open a Futures Trading Account: Apply to your selected brokerage/platform to open a futures trading account. Submit necessary documents, and provide identification and financial information. Fund your account with the required initial margin and additional capital.
- Simulated Trading: Consider using a demo account to practice and gain familiarity with the trading platform and strategies before risking real capital.
- Develop a Trading Plan: Develop a trading plan that defines your objectives, risk management, entry/exit strategies, position sizing, and schedule. It keeps you disciplined, and guides informed decisions based on predefined criteria, not emotions.
- Conduct Market Analysis: Use fundamental and technical analysis techniques to evaluate market trends, news, economic indicators, and price charts. Identify potential trading opportunities based on your analysis.
- Execute Trades: Once you have identified a trading opportunity, execute the trade. To do this, specify the type of order (buy or sell), the number of contracts, and any additional parameters. Monitor your trades closely and make adjustments as necessary.
- Practice Risk Management: Implement risk management measures to protect your capital and regularly assess and adjust your risk management strategy as needed.
Types of Futures Trading
Various types of futures exist in both the financial and commodity sectors. Here are different categories of futures:
These provide advantages such as leverage, allowing traders to control a larger volume of transactions with a smaller initial margin. However, the risks are also significant. They are traded on stock exchanges like BSE and NSE, but only for specific stocks.
These speculate on movements of indices like the Sensex or Nifty. Traders can profit if the index rises and face losses if it falls. Portfolio managers use index futures to hedge equity positions. Some examples include Sensex, Nifty 50, Nifty Bank, and Nifty IT.
These involve buying or selling a currency at a predetermined rate against another currency. They are used for hedging risks or by speculators. For instance, importers may purchase USD futures to guard against currency appreciation.
These hedge against price changes in various commodities and are used by speculators. While profit potential is high, risks are significant. Commodity futures are traded on exchanges like MCX and NCDEX for products like agricultural goods, gold, silver, and petroleum.
Interest Rate Futures
These involve contracts to buy or sell debt instruments at a specified price and date. Underlying assets are government bonds or treasury bills. These futures are traded on NSE and BSE.
How Does Futures Trading Differ from Other Financial Instruments
Futures trading differs from other financial instruments in the following ways:
- Contractual Obligation: Futures trading requires a contractual obligation to buy or sell an asset, distinguishing it from options trading, which provides the right but not the obligation to buy or sell.
- Standardisation: Standardised terms and conditions of futures contracts, including quantity, quality, and delivery date, ensure a regulated and efficient marketplace.
- Margin Requirement: Futures trading involves a margin deposit, a fraction of the contract value, allowing for higher leverage compared to other instruments.
- Liquidity: Futures markets are highly liquid, with active participation from institutional investors, speculators, and hedgers. This facilitates easy entry and exit from positions, providing ample trading opportunities.
- Price Transparency: Futures markets provide real-time price information, allowing traders to make informed decisions.
- Risk and Reward Profile: Futures trading offers both potential rewards and risks. Traders should carefully manage risk through strategies like stop-loss orders and position sizing.
- Range of Tradable Assets: Futures trading covers a wide range of asset classes, including commodities, currencies, stock indices, and interest rates.
With the integration of advanced technologies, such as artificial intelligence and machine learning, the rise of online trading platforms, like uTrade Algos, and the accessibility of information, regulatory bodies aiming towards enhancing transparency and mitigating systemic risks, and the possibility of asset classes including unique assets like cryptocurrencies, the future of futures trading sure holds a lot of potentials. Remember, though, that futures trading carries risks, and it is essential to approach it with caution and a well-informed mindset. Continuous learning is crucial. So, always stay updated on market trends, news, and new trading strategies.