Futures Trading: What Is It & How To Do It?

Futures trading can offer plenty of opportunities, but, as with any form of trading, there are risks involved. It forms a key strategic element for millions of traders around the world, so it's important to understand what it is, how it works and the associated pros and cons. Read on to find out more in our guide to trading futures. Please note that apart from our CFDs with futures as the underlying asset, you cannot trade futures with Tradu and this article is for informational purposes only.

What is futures trading?

Futures trading refers to the buying or selling of a futures contract. Futures traders engage in this practice to speculate on price movements or hedge existing positions. This process occurs within the futures market, where standardised contracts are traded on regulated exchanges to speculate on or hedge against price movements of various assets. These transactions occur on a futures exchange, where participants in the futures market can access a range of futures contracts.

Futures are contracts where two parties – a buyer and a seller – enter into an agreement to buy a futures contract or sell a futures contract at a certain price at a set date in the future (hence the name). They can agree to exchange before that point if they wish, but both parties are obligated to buy/sell at the pre-determined price if the position is held until the expiry date is reached.

You can trade futures using derivatives, which means you are speculating on an asset's price movement but not taking ownership of the asset. Many futures contracts are financially settled futures, meaning you don't take physical delivery but settle the difference in cash. For example, you might trade energy futures by predicting fluctuations in oil prices but you won't take physical ownership of the oil itself.

What's the difference between futures trading and options?

Futures and options are both types of derivative instruments used to speculate or hedge against market movements, but they differ significantly in terms of obligation and flexibility. You are agreeing to buy or sell at an agreed price at a specified point in the future. But when you trade futures, there is an obligation to exchange upon the expiry of the contract. With options, you have the right to buy or sell at that time, but there is no obligation. Options on futures provide this flexibility, while futures contracts create binding obligations for both parties. You simply have the option – hence the name.

What's the difference between trading futures and forward contracts?

The main difference between futures and forwards is their regulation. Futures are standardised agreements that can be traded on an exchange with pre-defined specifications. Forwards, on the other hand, are traded over the counter. The details of the agreement are set by the buyer and the seller, not a centralised body, so regulation is less stringent.

How does futures trading work?

Let's use oil futures as our example and assume that a contract is trading at $80 for 1,000 barrels. This example shows the basics of futures trading and how the value of the futures contract changes with market movements:

• You believe the price of oil is set to rise, so you buy the contract.
• The full value of your position is $80,000.
• Come the expiry of your contract, the price of oil has risen to $84 for 1,000 barrels.
• You sell the contract and exit the position.
• You have made a profit of $4,000, before any futures contract costs and commissions owed to your broker. This demonstrates how profit or loss is directly tied to the movement of the underlying asset in a futures position, which must be managed carefully.
• Conversely, if the price of oil dropped to $76, you would have lost $4,000.

The above is an illustrative example. The length of futures contracts can vary, so it's important to check the specifications before you enter into any position.

Which instruments can you use for trading futures?

You can access the futures market via contracts for difference (CFDs). CFD futures allow you to trade without opening a futures trading account or futures account with traditional commodity exchanges. These are financial derivatives that mean you do not have to take ownership of the underlying asset e.g. 1,000 barrels of oil. Instead, you are merely speculating on the future price movements of that asset.

CFDs are an agreement to exchange the difference in price of an asset between when the contract is opened and when it is closed. Unlike futures contracts, there is no pre-determined price or date at which you are obligated to buy or sell.

Trading futures using leverage

Trading on margin allows you to increase your market exposure from smaller deposits. This requires a margin account to access leveraged positions. It essentially involves putting up only a proportion of the required capital and borrowing the remainder from your broker.

The deposit you put up – known as margin – could be 5, 10 or 20% of the full value of your position. This margin system is essential for futures traders who want to maximise their market exposure. That percentage will vary depending on your broker and the assets you wish to trade. It will usually be displayed as a leverage ratio, with a 10% margin displayed as 10:1, for example.

The advantage of using leverage in futures contracts is that you could magnify your profits from a relatively small outlay. If we use the oil futures example outlined above:

• The full value of your position is $80,000, but let's say the margin requirement from your broker is 10%.
• That means you only have to put up $8,000, not the full $80,000.
• A net profit of $4,000 on an $8,000 outlay represents a healthy return.

However, the risk of using leverage in futures trading is that your losses can be magnified too. That's because you are exposed for the full value of your position, not just your deposit amount. So, in this instance, your net losses would be $12,000 – your initial $8,000 margin plus the $4,000 loss on the trade.

Which markets offer access to listed futures or exchange-traded futures?

Historically, futures contracts were used to buy and sell agricultural commodities such as coffee, sugar, timber and livestock. However, the emergence of futures means you can trade US-listed futures and international contracts across asset classes, including:

• Commodities such as gold, oil and natural gas.
• Shares in some of the world's largest companies e.g. Apple or Microsoft.
• Forex, with major currency pairs including USD/GBP and USD/EUR.
• Indices such as the S&P 500, the Dow Jones and the FTSE 100. Equity index futures like the S&P 500 futures contract allow traders to speculate on broad market movements, while stock futures focus on individual companies. Government bond futures, often used by institutional investors, help manage interest rate risk and are regulated by the Commodity Futures authorities. Another popular instrument is interest rate futures, which allow traders to hedge against or speculate on changes in benchmark interest rates. These are commonly traded through index futures, which enable traders to speculate on the future performance of an entire index rather than individual stocks.

How to trade futures: The different strategies

There are a few different ways to approach futures trading, so you need to settle on a futures strategy – or strategies – that work for you. Common examples include:

• Range trading: Identifying where the price of a futures contract typically trades within certain support and resistance levels, and buying and selling within that range.
• Breakout trading: Recognising where futures may be about to defy – or break out of – those traditional support and resistance levels and entering positions accordingly.
• Trend trading: Following an emerging trend and trading in that direction – for example, going long in a bullish market or short in a bearish one.
• Swing trading: Predicting reversals in those prevailing trends and capitalising on the market's 'swing' back in the opposite direction.

Your choice of trading platform can significantly impact your success, as it determines access to technical tools, risk management features, and real-time data execution. Consider market hours and trading hours when developing your trading strategy, as futures are highly sensitive to global events.

What are the advantages of engaging in futures transactions?

There are many reasons why trading futures is such popular practice around the world. Whether you want to start trading commodity futures or financial futures, understanding these benefits is crucial. Here are the primary benefits:

• Leverage: Trading futures on leverage offers the opportunity to amplify your returns from a relatively small initial outlay.
• Trade both ways: Because you trade futures using derivatives, you can predict a contract's price to go up or down. This enables you to profit in bearish markets as well as bullish ones.
• Hedging: You can use futures contracts and futures to hedge existing positions to offset your losses by shorting assets where you already hold long positions, and vice-versa.
• No overnight fees: There are typically no overnight charges to worry about when trading futures, even though positions are held over extended periods. Unlike some instruments, settled futures don't incur daily financing costs during the trading day. Other forms of trading can incur these fees, which eat into your profits.

What are the risks of trading futures?

• Leverage: While leverage can be a benefit, it also comes with inherent risk attached. Many accounts lose money when trading leveraged instruments, so risk management is essential. You are exposed for the full value of your position, not just your deposit. So, if the market defies your prediction, your losses could be amplified.
• Complexity: Futures are often complex instruments requiring significant knowledge. This introduction to futures covers basics, but thorough education is essential. You need to develop a solid understanding before you begin entering any positions, and the requisite monitoring and analysis can take a lot of time before you feel fully confident.
• Expiry dates: If you are trading multiple futures simultaneously, there may be several looming expiry dates for you to be aware of. And if there are sudden price movements or you lose track of your positions, you might find that the contract becomes worthless as you approach the expiry date. Remember that futures contracts may expire worthless, and futures are priced based on various factors including time decay.

Before you start trading, understand that futures contracts are sophisticated instruments. Futures are often used by experienced traders who understand how futures are priced and the risks involved. Whether trading micro futures or full-size contracts, proper education and risk management are essential for success.

Please note that apart from our CFDs with futures as the underlying asset, you cannot trade futures with Tradu and this article is for informational purposes only.