Now, we will examine the futures market, how it works, and what sets it apart from the other ones. Additionally, we will also see how using leverage can affect your investments.
Trading futures: how does it work?
A futures contract is a type of a derivative. If you are not familiar with this term, we will briefly address it now.
A derivative is any financial instrument that acquires its value from the price changes of a particular financial instrument. It means that it works by evaluating the price movement, rather than the inherent value.
Economic events and changes in the market are essential to a futures contract. The buyer and the seller agree that they will trade assets at a previously established price and date in the future. However, the agreement depends on the type of the underlying commodity and the time of its closing.
Usually, investors use these contracts to avoid risks and to speculate about the price movements of financial instruments. Still, they can be used for trading physical commodities as well.
It is essential to specify the expiration date of a particular commodity or financial instrument. For example, if you make a contract that requires physical distribution of the commodities. You would have to exit it before that date. Otherwise, you would have to deliver or accept the delivery of the commodities.
Futures contracts usually end with a cash settlement. Only 2% of these agreements require a delivery. That is because the trader would have to store the commodities somewhere, insure them, and then deliver them to the buyer.
When it comes to contract months, each has a specific letter. You can trade futures each month, and the contract month is when the agreement expires.
Having letters instead of months is something that can lead to a misunderstanding. That is why contact names always have a few other symbols. For example, if you make a contract in December 2017 for corn futures, its name would be ZCZ17. Contract names always require a ticker symbol, the month letter, and the last two digits of that year.
There are four main differences which set futures apart from other financial securities.
Firstly, unlike the others, they track the movement and price changes of other market instruments.
Secondly, they can also expire. In contrast to stocks, futures have a specific date of closing. After that, the agreement no longer exists. Therefore, timing and market directions are crucial factors to consider.
You have a variety of choices when determining the expire date. However, you have to remember that more extended futures agreements can costs you more money.
Furthermore, a longer contract can be illiquid – which means more expenses for the investor.
The third difference refers to spreads or outcomes of the market wagers. These depend on the relationship between different futures contract. Still, the most important characteristic of futures trading is the use of leverage.
How does leverage work?
Futures market owes its popularity to the leverage involved. Unlike stocks, they allow you enter a futures position that’s worth a lot more than the initial requirements. It is because the initial margins are lower when compared to the cash value of the agreements. The down payments on them are lower than when you are buying or selling stocks.
It all comes down to the value of your futures agreement. If the margin requirement is smaller, then your leverage can be higher. For example, if the ratio is 20:1, and you have $1,000 in your bank account. The entering position has a value of 20 times that amount – $20,000.
However, having leverage means that there is more risk. Your profit and your losses depend on the market changes. For example, you get a futures contract that trades at $2,600 with an initial margin of $5.000. If the value goes down or up – you are bound to lose or gain $50 for each point.
Losses and gains are significant even if the change is somewhat small. However, you can always curb your losses. Just make sure that you have a stop-loss order which protects you in case of bigger market changes.