FUTURES TRADING INFORMATION

Below you will find information on Futures Trading.

        

What is Futures Trading?

Futures trading is sometimes called commodity futures. It is an investment tool which allows investors to speculate on the future price of a commodity.

By trading futures, the investor does not actually buy or take ownership of anything. Instead, you speculate on the direction that you expect future prices will take. Trading futures involves speculating on price movements of commodities such as:

  • Metals including Gold and Silver
  • Grains such as Wheat and Corn
  • Meat such as Beef
  • Currencies
  • Timber
  • Energy (Gas, Oil)
  • Cotton
  • Bonds, Stocks, Indices

How does Futures Trading Work?

Trading between two parties the buyer and the seller takes place all over the world via central exchanges. The investor might choose to speculate on gold. If he thinks the price will be going up in the future, he will buy a futures contract. If, on the other hand, he thinks the price will be going down in the future, he will sell a futures contract.

Neither the buyer nor the seller must own any gold in order to carry out trade. They must however pay a certain deposit with a brokerage firm, which ensures that they will be able to pay the losses if either of their trades lose money.

Not just speculators carry out futures trading. Commercial producers and consumers also participate. They do so in order to eliminate risks from price fluctuations.

The Seller

For instance, a farmer might have a large field of wheat which will be ready for harvest in 2 months. He reckons that the price of his wheat will decrease within that time, so he will sell futures contracts to 'hedge risks' he will be paid the current price regardless of how the price of what changes in the two months until his crops are ready for harvest. He will deliver his wheat and fulfil his obligation under the futures contract.

The Buyer

Who bought the farmer's contract? Most probably a producer perhaps a baked goods company which produce large amounts of wheaten products (such as bread, cakes and so on). The producer wants to make sure he won't have to pay more than the current price of wheat when the farmer is ready to deliver it.

So, he buys a futures contract to protect himself if the price of wheat does increase within the next 2 months. Then, when the obligation date comes and he must receive delivery of the wheat, he will pay today's price for it regardless of whether the price of wheat has gone up.

Both the farmer and the producer are therefore hedging risks they are trying to protect themselves from price movement.

Speculators

But for investors looking for a way to speculate, there are futures for products like currencies, bonds and indices. The investor is also looking to hedge risk from future price changes, but is not interested in taking (or making) delivery of the physical commodities.

Instead, the trader offsets his position before the set delivery date. If the price of the underlying commodity has gone in the right direction, the trader wins. If the opposite happens, the trader makes a loss.

Speculators provide liquidity to the futures market.

Where does Trading Take Place?

Futures trading takes place via a central exchange a Futures Exchange. Traders can access trading platforms by registering with a brokerage firm and from there, they can see companies which are listed on the exchange. One of the world's largest Futures exchanges is the teamed-up Euronext and New York Stock Exchange. They provide inter-continental internet trading, so you can participate from all over the world from any location.

How much Money to Start?

When you open a futures contract, you pay an initial margin to the broker. This is a percentage of the value of the contract it is set by the broker and varies according to price movements. Typically the initial margin is between 2% and 10% of the contract value.

The fact that the investor only needs to pay a percentage of the full contract in the initial stage means that a relatively small amount of capital can be used to get going. However, margin trading does carry significant risk outlined later.

What about Regulation?

Each exchange is regulated by the government regulation body of their country. In Australia, this is the Australian Securities and Investments Commission (ASIC). The exchange is regulated as are the companies which are listed on it. Go to the ASIC website to see which companies are regulated.

What are the Advantages of Futures Trading?

Here are some of the plus sides to trading futures...

  • Leverage

Leverage means that not a huge amount of capital is required in order to begin trading you pay the margin as a deposit. The margin gives both you and the broker a level of security. You know that if your contract is winning, then you will make a profit. If you lose, the broker knows that they will have the deposit plus any additional funds required to cover the loss.

As you may have noted, this means that leverage is both a pro and a con. By paying a percentage of the full contract, you could multiply your wins but also your losses.

  • Liquidity

The futures market is a worldwide one, and is therefore very large. Massive volumes of trades take place all the time and when a market is very large, it provides lots of opportunities to buy and sell. Thanks to the modern system of online trading, it is easy and quick to place orders.

  • Speculation without Ownership

One of the key factors about futures trading is that you can speculate on price movement without having to take ownership of the commodity. While the farmers and producers are hedging risks for products which they will receive or deliver, online traders can profit from both price increase and reduction, by buying and selling ahead of the delivery date.

What are the Disadvantages?

Futures trading, like many other forms of speculative investment has a high risk factor. This in itself is one of the disadvantages of futures you could make significant losses. Here are some of the main drawbacks:

  • Leverage

Leverage was at the top of the list for advantages, and here it is at the top too. It is widely discussed that leverage has both a positive and negative nature. Here is an example of leverage during a loss:

The investor wants to invest $2,000. He uses this money to pay the initial margin and buy a futures contract for gold, worth $20,000.

You believe that the price of gold will increase within the set time frame of the contract but instead, it goes down by 10%. You have lost and will lose that initial $2,000 plus additional costs to cover the loss. A loss can exceed the initial margin plus the amount within an investor's account.

Many commentators recommend that investors use small amounts of capital to trade futures as this makes the impact at loss less severe. It is certainly worth making sure you fully understand the implications of your investments and if necessary discuss these with an impartial party such as an independent financial advisor.

Not Knowing your Product

Trading futures contracts can be a potentially lucrative investment plan but it does require a healthy amount of background work in order to have a chance at success. Even so, no matter how much you research and practise, you still stand the risk of losing capital.

Training, attending seminars (and webinars) and practising with virtual money (open a demo account with a broker) allows you to work on the risk factor by arming yourself with knowledge, tactic and analysis.

Pure guesswork is highly unlikely to land a person with profit.

What is the Difference between Futures and Options?

Many futures Exchanges offer investors Options contracts in addition to futures. They are quite similar to futures, only there are one or two key differences.

An investor opening an options contract means that they are given the right but not the obligation to buy or sell an asset.

The contract is agreed for expiration at a future date, at an agreed price similarly to a futures contract. With options, there are two types:

  • Call option

This means that the investor has the right to buy the underlying asset

  • Put option

This means that the investor has the right to sell the underlying asset.

In futures trading, the investor is obliged to take or make delivery of the underlying asset at the set expiration date. Because many investors want to remain just speculative i.e. they don't want to physically buy or sell the product they will either buy or sell their contract before the due expiration date.

What Fees are there?

The amount you pay for your futures trading activity depends on a number of factors for one, you might want a high level of advice, assistance and value-added service. This can cost extra as you are requesting specialist guidance on your trade activity. This might be in the form of management fees.

Alternatively, there are options to simply take an 'execution only' broker that means you take the majority of the control yourself. You decide where to buy and sell and when. This carries less fees but means you might need to be extra sure that you are fully informed and confident on how the system works.

Remember: brokerage firms are obliged to inform you fully of what fees and charges (including commission) are involved so make sure you read over the details fully.

What are the Risks?

Trading futures, as with any form of investment, brings risk to your capital. By opening a futures contract you could lose all of your invested money, your initial deposit plus there may be additional funds required.

Are you Suitable?

It is really important to remember this and therefore to evaluate your personal risk appetite and ability to cope with it. Perhaps you are more suited to a less risky investment plan? Perhaps a straightforward savings account which collects interest over time is more appropriate. Discuss this with an independent financial advisor.

Understanding Leverage

It is recommended that you only invest as much money as you can afford to lose so that if you lose money in futures, it won't make a significant change to your daily life (paying bills, buying food). Consider that most futures traders will lose money at some point.

Leverage means that while profits can be big, at the same time losses can be significant. Remember that you might be obliged to cover losses to the broker by paying additional funds. Make sure you understand the concept of leverage before you start to trade.

Consider Risk Management Strategies

You can't eliminate risk to your futures trading, but you can take steps to try and limit the amount of capital exposed to loss. Many traders place a Stop Loss or Stop Order on their contract. That means if the market moves against their position, it is automatically bought or sold when it reaches a specified price.

Please note that Stop Orders cannot guarantee that your capital is safe or that your order is met to the agreed price. Markets move very quickly (due to high volatility) sometimes so quickly that the pre-specified price cannot be met.

        


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