Diving into the world of trading can be incredibly exciting and overwhelming at the same time. Especially if you are looking to branch out and try investing in other different financial instruments aside from simple stocks. So, if you are looking to invest in futures, then we’ve written up a handy guide for your perusal. Hopefully, after you’ve finished reading, you’ll be able to better understand what futures are, their advantages and disadvantages, and how they can be used.
What are futures?
Futures are considered derivative financial contracts, meaning that they derive their value from their underlying asset (which can be a stock, commodities, bonds, mutual funds, and the like). This contract obligates the parties to either buy or sell the underlying asset at a predetermined date with a predetermined price. This is regardless of what the current market price of the asset is at the contract’s expiration date. Futures contracts are generally exchanged on a futures exchange.
Futures contracts can be used by a variety of people, ranging from investors to speculators, in addition to companies that take physical delivery of commodities or supply them (such as farmers, for instance).
Types of futures
There are many types of futures available to trade and invest in. A few common and popular ones include:
Financial futures: These futures consist of financial instruments like stocks, or indexes such as the Dow Jones or Nasdaq. Investors tend to use these futures to take advantage of anticipated market movements or financial announcements.
Energy futures: As its name suggests, the underlying assets of these contracts are based on energy – and that includes things like natural gas and oil. These contracts can also act as the benchmark for all oil prices worldwide.
Metal futures: Precious metals such as gold and silver tend to be the most common types of metals used as assets. Investors who generally choose these commodities are looking to hedge against inflation or other types of financial uncertainty. That being said, other metals can also be used for more practical applications, like platinum to make semiconductor chips.
Livestock futures: Traders and investors can even speculate on the price of livestock such as hogs and cattle. However, it is important to remember that price is based on consumer taste and supply and demand, as well as other standard risks associated with futures.
Agricultural futures: These contracts are generally based on assets such as corn, wheat, and soybeans, to name a few. These contracts are a little more unique in comparison to financial futures because weather and seasonality play a much larger role in impacting risk and prices.
Advantages of futures
So, what are the advantages of investing in futures? Why should people even do so in the first place? Well, here are a few reasons why. First, investors can use futures contracts to speculate on the direction of an underlying asset’s price. Companies can also use them to hedge on the price of raw materials or products that they may either sell or buy in order to protect against adverse price movements.
Futures contracts are also generally pretty cheap in comparison – they only require a deposit, which is a fraction of the contract amount with a broker.
Disadvantages of futures
However, there are still plenty of risks when it comes to investing in futures contracts. For instance, investors can risk losing a lot more than their initial margin amount, since most futures use leverage. This means that while investors can open larger trading positions with only a fraction of the price (due to borrowing money), their losses are based on the total value of the position, not just what they paid for it. As such, leverage can magnify losses if an investor is not careful enough.
Investing in futures contracts also means that everything is planned and predetermined. As such, it is not very flexible, and investors cannot make quick changes. For, they may end up missing out on favourable price movements of certain companies, especially if those price movements only occur for a short amount of time.
Futures for hedging
Futures can be used to hedge against risk and adverse price movement of the underlying asset in the market. This means that the main goal of the investor is to prevent any unnecessary losses from happening. Many companies that use futures contracts to hedge against risk tend to be using or producing and providing the underlying asset.
For example, a farmer can use futures to lock in a specific predetermined price when they need to sell their crops. By doing so, they guarantee that they will be able to receive the fixed price, thereby reducing risk. So, if say an adverse weather condition affects the quality of their crops, and most crop prices ended up falling, the farmer would have a gain on the hedge when they sell their crops to the market. In effect, this type of hedging can effectively lock the underlying asset in an acceptable market price for investors.
Futures for speculation
Another main use of futures contracts is through speculation on the direction of an asset’s price. So if a trader bought a futures contract and the price of their asset rose, they would be able to take advantage of them. Speculators can also take a short speculative position if they predict that an underlying asset’s price will fall sometime in the future. If the price does happen to do so, the trader can take an offsetting position to close out their contract. This means they would still be able to benefit from the decrease in price.
The bottom line
Futures contracts are derivative financial contracts that allow investors to buy and sell the underlying asset at a predetermined price at a future date. Futures contracts can be a fantastic way to not only speculate on the market but also to hedge against risk and adverse price movements that may end up happening. Overall, there are still a lot of risks when it comes to investing in futures, especially if a trader uses leverage. As such, all contracts should be carefully executed and monitored so that investors will not incur any unnecessary losses.
