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How to Trade Futures: A Beginner's Guide

Futures trading - A beginners guide

What is a futures contract?

A futures contract is a legal agreement between two parties to buy or sell an asset at a predetermined price on a future date. It’s a binding commitment traded on exchanges like CME Group.

The exchange also guarantees that the contract will be honored, eliminating counterparty risk. Every exchange-traded futures contract is centrally cleared. This means that when a futures contract is bought or sold, the exchange becomes the buyer to every seller and the seller to every buyer. This greatly reduces the credit risk associated with the default of a single buyer or seller.

Futures contracts are standardized, meaning they have fixed specifications for the underlying asset, quantity, and delivery date.

Traditionally, futures trading allows the owner of the contract to buy something, say barrels of oil, at a specific price on a specific date. They bring an element of predictability for buyers of commodities, for example. Airlines that want to make sure they can lock in the price of future oil at a price they can afford.

Futures markets were created to allow these contracts to change hands. Most futures traders today do not intend to actually take delivery of an asset – see more on expiry dates below.

These contracts are commonly used for commodities, financial instruments, and other assets, allowing investors to speculate on price movements or hedge against potential losses. With futures, traders can take advantage of leverage to amplify their returns, but it’s essential to understand the risks involved.

Learn more about futures with CME Group’s free online educational courses, available on The Armchair Trader.

Commodity futures are contracts that allow buyers and sellers to agree on a price for a specific quantity and quality of a commodity to be delivered at a future date.

For many commodity markets there will be both a “spot” or cash market as well as a futures market. The difference between the spot market and the futures market is referred to as basis. Due to the efficient market structure, spot and futures markets tend to move in a correlated manner. Since many futures contracts are physically delivered, as the futures contract moves closer to expiration the futures and spot prices will converge. Commodity markets like crude oil, gold, natural gas or soybeans all function on the basis of futures.

Producers, like farmers or mining companies, use futures to lock in prices for their goods, protecting themselves from price fluctuations. Consumers, such as food manufacturers or airlines, use futures to ensure a stable supply and price for their raw materials. Speculators trade commodity futures to profit from price movements without intending to take or make delivery of the physical commodity. This interaction between market participants helps in price discovery and risk management. For retail traders, physical delivery is rarely a concern, as most positions are closed before the contract expires.

Futures contracts have expiration dates that determine when the agreement must be fulfilled. Each product has its own expiration schedule, which can be monthly, quarterly, or even weekly. For example, crude oil futures on the CME expire monthly, while E-mini S&P 500 futures have quarterly expirations. This allows traders and investors to take a view on the direction of prices over a longer period of time by buying/selling longer dated contracts.

As the expiration date approaches, traders must decide whether to close their positions or roll them over to the next contract month. For most retail traders, physical delivery is not a concern, as positions are typically closed before expiration. However, it’s crucial to be aware of the expiration dates and the potential impact on your trading strategy.

Futures and Exchange Traded Funds (ETFs) are both popular trading instruments, but they have distinct characteristics. Futures are derivative contracts with set expiration dates and they trade nearly round the clock six days a week. They allow traders to express an opinion on price movements or hedge their positions. ETFs, on the other hand, are investment funds that hold a basket of securities and trade like stocks on exchanges. They provide investors with exposure to a diversified portfolio and are generally considered less risky and more suitable for long-term investing. It’s essential to understand the differences between these instruments and choose the one that aligns with your investment goals and risk tolerance.

We explain the similarities and differences between futures and ETFs in our free online course, in conjunction with CME Group. 

There is an ever-increasing range of futures contracts to choose from.

Equity Index Futures are becoming increasingly popular for futures trading. These contracts track the most popular Index funds such as S&P500, Nasdaq, and Dow Jones Industrial Average. The futures market is open nearly 24 hours a day, six days a week, so when the stock market is closed you can still react to market moving events in the futures market..

Beyond the well-known commodity and financial futures, there is a diverse range of futures contracts available for trading. Interest rate futures, such as Treasury bonds, enable traders to manage interest rate risk or express an opinion on rate movements. Currency futures allow you to express an opinion on foreign exchange risk.

Many of the above markets also offer contracts in multiple sizes. These smaller-sized or Micro contracts offer the same benefits of their larger contracts, while allowing more granularity and flexibility to fine-tune trading and risk-management strategies.

Futures trading can be used to protect yourself against changes to your existing portfolio of stocks. For example, an investor with a large stock portfolio might sell stock index futures to hedge against a potential market downturn. If the market declines, the losses in the stock portfolio would be offset by gains in the short futures position.

Futures trading can also be an effective hedging tool for businesses looking to protect themselves from adverse price movements. For example, an airline might buy jet fuel futures to lock in prices and protect against sudden spikes in fuel costs that could impact their bottom line. By using futures to hedge, investors and businesses can reduce their exposure to price risk and maintain more stable returns.

However, it’s important to remember that hedging is not a guarantee against losses and requires careful planning and execution.

While some futures contracts have high minimum contract sizes, some exchanges like CME Group have introduced cheaper contracts to attract private, or individual, futures trading. The most popular E-mini contracts are based on stock indices, such as the S&P 500, Nasdaq 100, and Dow Jones Industrial Average. These can change hands for a fraction of the cost of conventional futures on these indices, and allow US and foreign traders to trade an exchange-based contract on the S&P 500 with less capital.

Despite their smaller size, E-mini or Micro futures offer the same benefits as standard futures, including leverage, flexibility, and the ability to go long or short. They are an attractive option for individual traders looking to diversify their portfolios, speculate on market movements, or hedge their existing positions. The market for futures trading is heavily exchange-traded now, making pricing more efficient and transparent – however, it’s crucial to understand the risks associated with leverage and to manage your positions responsibly.

The E-mini futures concept has led to a broad market of cheaper index futures, including Nikkei 225, and Russell 2000, and Micro futures on major currency pairs like GBP/USD or USD/JPY. If you would like to learn more about e-mini futures, see our free online futures trading course here

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