Trading Futures: The Essential Guide for Beginners
Most investors are familiar with investment vehicles like mutual funds, stocks, bonds, ETF’s and even commodities, but few are knowledgeable about futures. A basic futures contract is simply an agreement between a buyer and seller to buy or sell a particular asset at a specified price on a specified date.
Futures were originally designed for farmers who wanted to be able to hedge their bets against price changes in the crops they grew. Between the time a crop is planted and the time a crop is harvested, the price of that commodity could change for the worse. Instead of risking loss on a crop, a farmer can instead trade a futures contract that locks in an earlier price where a profit will be guaranteed. Of course, if the price of the crop goes up the farmer will miss out on the opportunity to sell at the higher price.
While futures started as agricultural commodities, they now cover oil, natural gas, metals, interest rates, foreign currencies, bonds and even stock indexes and are available to anyone to trade.
Dipping your feet in the futures market
Investors who are familiar with stock trading may find it difficult to adjust to certain peculiarities of futures. One of the biggest differences is the way futures are settled. A method known as a mark-to-market accounting means that positions are tallied up at the end of every business day to ensure that margin requirements are met. While that might not seem like a major obstacle to deal with, the fact that futures tend to use leverage means investors could theoretically lose their investment in a single trading day.
Leverage in stock accounts usually means borrowing money on margin in order to invest more money into stocks. But the leverage is less than double the initial amount, making it much safer than futures. Futures contracts can use leverage as high as 200:1, making even a 1 percent change in a single day a huge deal. Investors can earn profits far in excess of those they could earn in stocks, but at an equally high cost with the risk of losing it all just as easily.
With mark-to-market accounting, investors can actually be right in the long-term about an asset, but due to a single day fluctuation, lose their investment principle. Investors need to consider the risks before investing in futures.
While many brokers allow futures trading, most have fairly strict requirements that need to be met in order to trade. A margin account is a must, meaning your credit score comes into play, while the initial amount needed to trade a futures contract can be in excess of $50,000 per trade. For investors interested in trading futures, they should carefully consider how it fits into their portfolio strategy.