What is Futures Trading? A Complete Guide

If you’ve ever wondered about trading beyond stocks and bonds, you might have come across the term futures trading. But what is futures trading, exactly? Futures trading refers to the buying and selling of futures contracts, agreements to buy or sell an asset at a predetermined price on a future date. Unlike traditional investing in shares, futures trading involves contracts that specify the price and delivery date of assets like commodities, currencies, or financial instruments.

Futures are popular among investors, traders, and companies that want to hedge risk or speculate on price movements. They form an essential part of the financial ecosystem and are traded on specialised futures exchanges worldwide. This market plays a critical role in helping businesses manage price risks associated with fluctuations in commodities such as crude oil, gold, or agricultural products, as well as financial assets like interest rate futures.

In this article, we’ll explore how futures trading works, how you can start trading futures, and the benefits and risks involved. Whether you’re a beginner or looking to deepen your knowledge of stock markets futures, this guide will help you navigate the basics and beyond.

How Futures Contracts Operate?

Futures trading centres around contracts called futures contracts. These contracts obligate the buyer to purchase, and the seller to sell, a specific quantity of an underlying asset at a set price on a future date, known as the delivery date. The underlying asset could be anything from crude oil and gold to stock indices and government securities.

To enter into a futures trade, both parties agree on a contract size (the amount of the underlying asset covered), the price, and the delivery date. However, in many cases, traders do not hold the asset until delivery. Instead, they close out their positions before the delivery date to realise gains or limit losses.

Futures trading requires an initial margin, a security deposit paid upfront to the broker or exchange to open a position. This margin is only a fraction of the total contract value, making futures trading highly leveraged. Leverage amplifies both potential profits and losses, which is why managing risk is critical.

There are two primary positions in futures trading:

• Long position: You agree to buy the asset in the future, betting that its price will rise.
• Short position: You agree to sell the asset in the future, speculating that its price will fall.

The price of the futures contract fluctuates daily with the underlying asset, and these changes are settled daily through a process called marking to market. This means gains and losses are credited or debited to traders’ accounts every day.

Getting Started with Futures Trading

Starting futures trading requires some preparation and understanding of how futures markets operate. Here’s a step-by-step guide to help you begin:

1. Educate Yourself: Learn about futures markets, different types of futures contracts, and key terms like contract size, margin requirements, and settlement methods.
2. Choose a Futures Broker: You’ll need to open an account with a broker that offers access to futures exchanges. Check their commission rates, margin requirements, and trading platform usability.
3. Fund Your Account: Deposit the required margin funds. Remember that futures trading can be volatile, so start with an amount you can afford to lose.
4. Select Your Futures Contract: Decide which futures contract you want to trade, whether commodity futures like crude oil, or financial futures like interest rate or stock index futures.
5. Place Your Trade: Decide your position, whether long or short, and enter the trade through your broker’s trading platform.
6. Monitor and Manage Risk: Use stop-loss orders and maintain margin requirements. Futures trading can be risky, so having a solid risk management strategy is vital.

Different Types of Future Contracts in Futures Market

Futures contracts are traded on regulated futures exchanges, where buyers and sellers meet. Some popular futures exchanges include the CME Group, ICE Futures, and the National Commodity and Derivatives Exchange (NCDEX) in India.

There are several types of futures contracts:

• Commodity Futures: These cover physical goods like crude oil, gold, silver, agricultural products (wheat, corn, coffee), and more. Commodity producers and consumers often use these contracts to hedge price risks.
• Financial Futures: These include futures on stock indices, government bonds, interest rates, and currencies. Traders often use these contracts to speculate or hedge against financial market risks.
• Stock Futures: Contracts based on individual stocks, allowing investors to speculate on stock price movements without owning the shares directly.

Futures contracts are standardised, meaning contract size, delivery date, and quality specifications are predefined by the exchange. This standardisation ensures liquidity and ease of trading in stock markets futures.

Step-by-Step Guide to Trading Futures

Trading futures is slightly different from trading stocks or ETFs. Here’s how futures trading typically works:

1. Opening a Position: You either buy a futures contract (go long) if you expect prices to rise, or sell a futures contract (go short) if you expect prices to fall.
2. Margin Requirements: You must deposit an initial margin, a fraction of the contract’s full value. You may also have to maintain a maintenance margin to keep your position open.
3. Marking to Market: Every day, gains or losses are calculated based on the daily price movement and credited or debited from your account.
4. Closing or Rolling Over: You can close your position before the contract expires by taking an opposite position, or roll over to a new contract to maintain exposure.
5. Settlement: If you hold the contract until expiry, it can be settled by either physical delivery of the asset or cash settlement, depending on the contract terms.

It’s important to have a clear trading plan, including entry and exit points, stop losses, and position sizing, to effectively trade futures and protect your capital.

Challenges Involved in Futures Trading

While futures trading offers significant opportunities, it also carries substantial risks that traders must be aware of:

• High Leverage: Because you only put down a margin, small price movements can cause large gains or losses, magnifying both rewards and risks.
• Market Volatility: Futures prices can be highly volatile due to geopolitical events, economic data releases, or sudden shifts in supply and demand.
• Margin Calls: If your account value falls below the maintenance margin, you’ll face a margin call, requiring you to add funds or close positions.
• Complexity: Futures trading requires understanding contract specifications, expiry dates, and settlement processes, which can be complex for beginners.
• Potential for Unlimited Losses: Unlike stock investments, where losses are limited to your investment amount, short positions in futures could lead to theoretically unlimited losses if prices rise sharply.

Due to these risks, futures trading is generally recommended for experienced traders who can dedicate time to market analysis and risk management.

Final Thoughts

Understanding what is futures trading is essential for anyone interested in the world of derivatives and advanced trading strategies. Futures contracts provide an opportunity to hedge risk, speculate on price movements, and diversify your investment portfolio. However, the high leverage and volatility involved mean futures trading requires education, experience, and disciplined risk management.

Whether trading commodity futures like crude oil or financial futures based on interest rates, knowing the mechanics and risks will help you make more informed decisions. If you’re considering entering the futures markets, start with small positions, learn continuously, and work with experienced brokers to navigate this exciting but complex financial arena.