Table of Contents
What is futures trading?
How is futures trading regulated?
Things to consider before trading futures
How to trade a futures contract
Are futures and forwards the same thing?
The bottom line
Jun 21, 2022
7 min read
Futures trading is the purchase or sale of a contract in which one party agrees to deliver to another something of value at a specified price at some future date.
The futures market is where contracts are traded for commodities and financial products, at prices agreed upon today for delivery of goods or cash settlement in the future. The futures price is set regardless of changes in the underlying asset’s spot market price for immediate payment and delivery.
Futures are called derivatives, because they are derived from underlying assets, such as crude oil, wheat, the Standard & Poor’s 500 Index, and so forth. They are traded mostly through futures exchanges. The two biggest in the U.S. are the Chicago Mercantile Exchange and the Atlanta-based Intercontinental Exchange. Almost all trading is now done electronically rather than by traders jostling in trading pits. Unlike stock market trading during set hours, futures trading is done around the clock.
Futures trading is the purchase or sale of a contract in which one party agrees to deliver to another something of value at a specified price at some future date. Apart from the terms of the contract, the contract itself has value, based on supply and demand and expectations of the price of the underlying asset.
Although individuals can trade futures, most trading is done by hedge funds, farmers, food processors, energy producers, and refiners. They typically want to either hedge or guard against adverse prices moves or they want to speculate on those changing prices.
The structure of the market is a deterrent to small investors. For one thing, futures are large, often $100,00 or more for a single contract, and futures exchanges require a portion of each contract’s value pledged up front, an amount known as margin. The margin required for one U.S. crude oil futures was about $13,000 when crude was about $100 a barrel in early 2022, for example.
“If you’re just running a regular financial portfolio, there’s no reason that you would need to include futures,’’ said Myles Udland, an investment strategist for Titan.
Futures were first used in agriculture for farmers to get a sure price for their crops at harvest time; their use eventually expanded into other natural-resource markets such as energy and metals.
The market has grown with financial futures contracts pegged to stock indexes or the interest rates on government bonds. Financial futures now dominate the market because they have broader use for hedging or speculation than futures linked to specific commodities.
The market for futures and other derivatives in the U.S. is regulated by the Commodity Futures Trading Commission, established by Congress in 1974. At the time, most futures trading was in agricultural commodities. Since then the market mushroomed, with the creation of futures in crude oil, natural gas, Treasury bonds, foreign exchange and stock indexes. This growth, along with the advent of cryptocurrency futures, has made the CFTC’s mission more challenging.
The National Futures Association is a designated self-regulatory organization for derivatives markets. Future exchanges also are self-regulating, enforcing margin requirements and other rules, and guaranteeing that trades are fulfilled. Traders can be denied access to exchanges if they fail to honor contracts or don’t respond to calls for maintaining their margin accounts.
Investors who plan to engage in futures trading must weigh the potential opportunities against the risks.
Futures can be attractive because of 24/7 electronic trading, and exchanges now offer smaller, more manageable versions of traditional futures contracts. For example, a micro crude oil contract covers 100 barrels, a 10th the size of a regular contract; similar versions of stock-index futures are available.
Because investors are required only to deposit a small fraction of a contract’s value as margin, futures trading is highly leveraged. Stock trading, by comparison, typically requires 50% margin, allowing much less leverage.
Leverage has two sides: Gains can be magnified if the investor bets right on the price direction of the contract's underlying asset. But leverage magnifies losses if the price of the asset goes against the investor, who will be required to pledge more margin money as the futures contract loses value. This process, known as marking to market, is the biggest risk in futures trading.
An investor considering a futures trade usually takes several steps before proceeding.
Which underlying asset market does the investor understand best, how is it measured and how is it priced? For example, oil is priced by the barrel, grain by the bushel, stocks by an index value, and principal or face value for government bonds.
Futures are traded in standard multiples of the asset: for example, 1,000 barrels for an oil contract, 5,000 bushels for a grain contract, 250 times the stock index, 100 times the principal of a U.S. Treasury bond. Exchanges now offer smaller versions of the most popular contracts, called mini and micro futures, to attract more investors and expand trading.
A futures contract will specify if it’s priced in dollars or another currency, and detail the terms of settlement—the cash difference, or physical delivery of the asset.
Many of the biggest brokerage firms include futures trading among their services, especially online. Some cater more to professional investors and have higher costs and requirements to access the market. Investors can compare and contrast brokers by services offered and associated costs.
Some brokers allow novice investors to practice by doing simulated futures trades in a dummy account, called paper trading, to get a better understanding of the futures market and mechanics before committing money to real trades.
Brokers may charge a trading commission. Widely traded commodity futures may cost less than a dollar to trade, while Bitcoin futures may cost up to $10. Investors should also be aware of any charges for access to online trading and data.
Futures trading requires that an investor establish a margin account at a broker to deposit a percentage of the contract value. Margin requirements are set by exchanges and vary, depending on the price volatility of the underlying asset and how easily the futures are traded. The Chicago Mercantile Exchange, for instance, has a margin range of about 3% to 12%; popular commodities and stock indexes tend to be lower while cryptocurrency futures have higher margins.
After settlement of a futures trade, any margin balance is returned to an investor.
Most futures contracts are closed out before they expire, by traders taking equal and opposite futures positions, so they offset each other. A trader who bought 10 crude oil futures and didn’t want to take delivery of 10,000 barrels, would sell 10 identical crude futures, with price differences settled in cash.
As a general rule, small investors trade futures that can be settled in cash to avoid the impracticality of accepting delivery of or storing large quantities of physical goods.
Forwards are customized contracts between two parties and may have different asset types, quantities, and delivery or settlement dates. They are similar to futures in that both are contracts that will be settled in the future, for prices and terms of settlement now.
But they are different in other respects:
The futures market brings together two types of traders: hedgers who want to avoid the risk of price volatility by agreeing to a price now for an asset in the future, and speculators who accept the risk, betting price volatility will work in their favor.
Many brokerages offer futures trading services, and exchanges now offer smaller versions of traditional large contracts, to make futures more accessible to small investors. Small investors who do trade futures generally are in the role of speculators. Still, the upfront costs, margin requirements and high leverage can make futures investing riskier than stocks, options and bonds.
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