Futures are a form of financial derivative contracts that can be used as a hedge against certain price drops in the market and also for speculation. Futures contracts were initially designed for farmers to protect their investment from changes in the price of crops between the period of planting and harvesting. It’s no wonder why most future contracts up to this day are based on things like livestock and grains. However, the market has expanded over the years to accommodate other types of assets such as stocks, oil, bonds and industrial metals.
THE DIFFERENCE BETWEEN FUTURES TRADING AND OTHER FINANCIAL INSTRUMENTS
Unlike other financial instruments you know of, the value of a future contract will be derived from the price movement of another item. The future contract itself does not possess any intrinsic value. The other distinct feature of future contracts is that they have an expiry date. When this date elapses, the contract is deemed worthless and it ceases to exist. This is unlike other financial instruments such as stocks that can exist forever.
Because future contracts have a finite life, the timing is important when it comes to this form of trading. Future contracts that span for long periods of time are usually more expensive than the shorter contracts. This may be because with a longer period of time, you have an extended period for your speculations to turn true.
The main distinction between futures and other forms of investment is in the use of leverage. Futures trading allow you to invest with a small initial amount. This is because when buying or selling the contract, you do not need to pay for the whole amount during initiation. You just need to make a small upfront payment which is usually known as the initial margin in order to initiate a trade. This means that you are able to achieve a large profit even after making a modest initial investment. This is one of the main reasons why many retail investors like to trade future contracts. However, you need to understand that leverage usually works both ways and the investor also runs the risk of losing the entire initial margin if the commodity falls in value.
WHY FUTURES TRADING?
Future contracts are mainly used for risk mitigation by either party. The two parties will put up an initial investment, which is the margin usually set as a percentage of the entire value of the contract and must be maintained throughout the life of the contract for it to be deemed viable. The prices of the commodity are re-evaluated daily because fluctuations occur due to demand and supply. When the initial amount that was put into the futures trading account goes beyond a certain value then the owner of the account has to replenish it. The margin is what minimizes the credit risk and it is typically 5-15% of the contract’s value. Futures trading has its risks too; you need to understand the terms and conditions of this contract before you decide to consider it as a form of investment.
BENEFITS OF FUTURES TRADING
When looking at investment options, most people will begin with stock trading. But as they gain experience in stock trading, they come to realize the potential benefits of other forms of trading such as futures contracts. The following are the benefits of futures trading;
Leverage With future contracts, you can initiate a trade worth $65,000 for as little as $500. The margin required is usually less than 10% of the total cost of the trade. The fact that commodities can be traded with low margin requirements means that even small investors can make profits with small market movements.
24-hour trading opportunities Most future markets are available 24 hours a day. This means that you get an opportunity to trade around the clock and take advantage of opportunities as they arise. This diverse opportunity is key for managing risk.
Tax benefits Profits obtained from futures contracts are taxed 60/40. This means that the 60% profits will be taxed at the maximum rate of 15% whereas the remaining 40% will be taxed at a maximum rate of 35%. However, take note that the tax situation may defer from person to person so it’s important to consult an accountant regarding this matter.
Invest in very liquid markets Future markets are very liquid because of volumes of participants. Money is traded in huge numbers and you are almost guaranteed of a constant supply of buyers and sellers. The orders can be made fast and also prices do not fluctuate drastically.
Low commissions The commissions of future trades are quite reasonable compared to other forms of trading. The commissions are also charged after the position is closed. The amount of commission you pay will depend on the level or type of service that is offered by the broker but it can be typically as low as 0.15% of the total contract value. You also have brokers who charge a fixed value say, $70 per trade.
Diversify your investment portfolio Futures trading has been used by many investors for diversification or hedging. With futures contracts you can manage different types of risks such as interest rates risk, price risk and foreign exchange risk. Price risk can be mitigated by locking in the price of a commodity. Furthermore, when it comes to futures, the cost of purchasing an asset is made incredibly low because you do not have to purchase the entire commodity.
Benefit by short selling In futures trading, short selling is allowed. You can sell your futures and get short exposure. However, it’s important to understand that some prohibit short selling of stocks so you need to know the terms of your futures contracts before signing up.
Security Futures trading is protected by the CFTC (Commodity Futures Trading Commission) which is regulated by NFA (National Futures Association). There are rules in place to safeguard customer funds and a good track record of customers never losing their funds in the futures market hence there is a very low likelihood of your investments going down the drain.
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