At its most basic level, a futures contract is a commitment to purchase or sell an asset at a predetermined price at a future date. The contracts usually involve commodities such as metals, oil, agricultural produce, currency, among a variety of other assets.

A futures contract is one in which one party promises to acquire a specific volume of securities, commodities, or other underlying assets and take delivery on a specific date. The vendor commits to fulfill their end of the bargain. Trading in these instruments usually takes place in futures exchanges.

There are numerous types of financial participants who can use the futures market, including merchants, speculators, and companies that actually want to trade in goods in their physical form. It also contains a large variety of assets. 

Futures exchange floors have “pits” where traders transact business, and each futures contract has its own defined area. Retail investors and traders, on the other hand, can use a broker to access electronic futures trading.

 A real-world illustration

  • Futures were initially devised as a way to lock in commodity prices. It all began with investors looking for security and predictability in their investments.
  • Imagine you’re a corn grower. You are in the business of growing and selling corn. Meanwhile, a bushel of corn currently costs $5. However, you’re worried that prices may fall in the next three months, reducing your profit margin. As a result, you’d want to secure today’s price.
  • It is better to short futures contracts that expire in three months. Selling short entails taking a position on the corn’s future decline. In such a case, even if corn prices fall, the gains in futures contracts will more than make up for the loss in your business. 

Futures trading considerations

In order to be successful in the futures market, you must know the following:

  • Leverage: This is the ability to control a substantial investment with a small sum of money.  If you choose to leverage your position, there is the potential for high returns, but there is also the possibility of substantial losses.
  • Diversification: A wide range of assets are available to you in the futures markets. Examples include soybean, corn, wheat, metals, crude oil, indices, among others.
  • After hours: Futures markets are open all hours of the day and night. Futures markets can also provide insight into how the underlying markets will open. Gold futures, for instance, can tell us whether gold stocks are likely to open lower or higher.  
  • Liquidity: The futures market has a lot of trade, especially in high-volume contracts, which means there is plenty of liquidity. There will be fewer barriers to entering and exiting trades. When dealing with less well-known contracts that have lesser volumes, it’s possible that liquidity issues may arise.
  • Hedging: It is possible to hedge current positions in commodities or stocks by using future contracts to safeguard profits that have not yet been realized or limit losses that have already been experienced. Rather than just leaving your existing position, you now have an option. Hedge your long portfolio by selling your long position and buying the short one.

How to trade in futures contracts

  •   Recognize the risks and take precautions to avoid them

As leveraged investments, one of the basic concepts in futures trading is using a little amount of cash to control a much higher contract value. Even though this type of leverage allows for more effective use of cash, it also comes with a risk of magnifying losses considerably beyond what was initially invested.

Before you take a position in the market, prepare your trades carefully to help protect yourself from suffering a significant loss. If the trade goes against you, have an exit strategy in place.

You’ll also need a futures-approved brokerage account before getting started. 

  •   Understand trading margin

An initial margin is required to protect the investor before a futures contract can be finalized and a maturity date assigned. At least 10% of the asset value must be invested by both buyers and sellers in order to participate fully in a futures trading transaction

Futures trading brokers and exchange companies will hold this margin as insurance in case one or both parties to the transaction suffer losses. Therefore, you should prepare for your futures transaction in the same way you would for an equity trading strategy.

  •  Decide on which futures market you want

As a beginner, it is a good idea to start trading futures on markets that you already know a lot about. For example, you can consider soybean futures as an option if you’ve already invested in agricultural firm equities before. 

By concentrating your efforts on only one or two financial markets, you will be able to devote more time and attention to your trades for better results.

By researching important fundamental and technical data, you can build an opinion on the market’s likely future price movement, just as you would when evaluating an equity trade.

  • Put your trading strategy into action and keep track of it

Your futures account can be used to establish a position by placing an execution order once you’ve decided on a futures contract and developed a strategy for trading it.

Exit strategies, such as stop orders and/or bracket orders, should always be considered while placing a trade.

Following the submission of your order, it will go out into the market and be matched with a purchase or sale order for your contract, depending on your preference.

To minimize your risk, even if you have a futures position set up and protective orders in place, it’s important to be vigilant and ready to reassess your exit strategy or take action if the market shifts.

In summary

As a result of buying futures, buyers are obligated to buy the underlying asset, while sellers must sell at the contract’s expiration date. Futures are therefore essential tools in trading since they allow investors to lock in asset prices and protect themselves against potentially unfavorable price fluctuations.