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Futures trading is an integral part of any business today.
Traders can make huge profits by knowing how to play the game, while companies can hedge risk on their balance sheets by using these instruments.
Futures are financial contracts that allow two parties (futures trader and counterparty) to exchange something at a future date with an agreed price set now; thus, they act as both insurance on the underlying asset and as a tradable instrument in themselves.
Although futures trading began around 500BC in India, it boomed in popularity in 17th century Japan when merchants used rice futures to lock in prices for their upcoming harvests.
By the 19th century, most countries had some form of futures markets allowing farmers, businesses and traders to fix prices on commodities they were trading, thus reducing the risk of default.
A futures contract has the underlying asset and a futures price.
The underlying asset can be anything from an agricultural good (e.g., corn, wheat), stock indexes (e.g., FTSE100) or a metal (e.g., Gold).
Futures are usually traded in hundreds of units for the less popular contracts and around 50 units for more liquid contracts.
For example, if you buy one lot of gold futures trading at $1,350 per ounce, this means that you have bought 50 ounces of gold worth at today’s spot price ($1,350 x 50 = $67,500).
The futures price will be slightly higher than the spot price to provide a profit margin when you sell it. This profit margin can vary depending on factors, mainly supply and demand in that particular commodity.
For example, if the underlying assets are grain, this may impact weather conditions, which in turn affects supply levels.
Trading futures contracts
When trading futures contracts, exchanges take two types of fees; one is a daily settlement fee towards the exchange itself, and the other is an ongoing commission fee charged by your broker for making transactions.
If you decide not to roll over your futures contracts, you will have to sell them back on the market.
If there is a lot of slippage between the buy and sell prices, you might lose some of your initial stakes or incur a loss.
One way of avoiding this problem is by using sound risk management techniques such as stop-loss orders.
In terms of volume traded, the most popular futures contract is crude oil which accounts for around 33% of total turnover, followed by government bonds at 19%.
It implies that if you wish to trade in these assets, it’s advisable to use brokers who offer CFDs or spread betting on those markets instead of traditional contracts where liquidity levels are lower and hence not suitable for beginners.
The London InternationalFinancial Futures Exchange (LIFFE) was the first-ever futures trading market in 1982.
In 2001, after a series of mergers, LIFFE became part of the London Stock Exchange, creating one sizable general index instead of individual indices for each asset type.
Standard & Poor’s later introduced a set of six main indexes, which were extended to cover 23 countries and 11 sectors.
Since then, numerous other exchanges have copied the trend and now allow customers to trade futures in various markets, including commodities, currencies, US and UK interest rates.
Traders who can now diversify their portfolio with only one contract may take comfort in the fact that liquidity levels are generally lower than traditional contracts, increasing the danger involved when deciding not to roll over your contracts.
Futures trading is similar to gambling, as the only way to make money is by speculating on changes in prices.
However, experienced traders may use more advanced techniques such as hedging and arbitrage to make a profit rather than just looking at the movement of futures prices alone.
It may sound like the best idea, but it’s essential to understand that not all contracts are liquid and successful execution relies on your broker being able to purchase or sell for you at the best price.
Also, you need enough capital available to avoid any losses if prices move against you, resulting in high slippage costs.
Link to futures trading for more information.