Guide to Trading Futures
Futures are contracts to sell or buy some asset at a set price within a pre-agreed period. They involve two types of assets – financial instruments and commodities. Some traders go long or short for speculative purposes.
Benefits for Traders
Trading futures involves plenty of benefits, including mark-to-market treatment, preferred tax rates, leverage, and electronic trading. Other benefits include safety of investments, direct correlation, portfolio diversification, and liquidity. Traders benefit from segregated accounts, financial safeguards, and electronic access. They also use futures because of the small commission charges. Finally, this is a type of leveraged investment which allows investors to trade large volumes.
Portfolio Managers and Other Types of Traders
Three types of traders deal with futures – portfolio managers, speculators and hedgers. Portfolio managers hedge and invest in assets that are held in different funds, including closed-end, exchange-traded, and mutual funds. They invest in futures to limit or maximize market exposure and for portfolio diversification. Hedgers cover a variety of investments such as gold, stock index, and commodities such as beef, wheat, steel, lumber, corn, and others. Mining companies, farms, and other producers trade futures contracts. The goal is to limit price risk and optimize long-term planning. Individual investors also trade futures for financial gains. Other players include market makers, hedge funds, and proprietary trading firms.
How Trading Futures Works
Futures are standard contracts trade commodities or financial instruments while forward contracts are in the form of cash-market agreements to deliver a commodity. The main difference between both instruments is that forward contracts are non-transferable. When trading futures, investors take a number of factors into account, including contract value, contract size, price limits, and others.
Real-life Example
Different players participate in the market. Wheat, corn, and cotton producers, for example, are at risk due to factors such as price fluctuation. If demand for cotton is low and the harvest is good, then cotton prices are expected to fall. One way to minimize risk is to hedge against falling cotton prices. What producers can do is hedge the sales price of cotton. They may hedge a portion or all of their produce based on factors such as market conditions and risk. Farmers that sell futures actually transfer some of the risk to third parties. The goal is to manage volatility and risk. If cotton prices fall, farmers can repurchase the futures at a reduced price. They can use the profit to cover a portion of the losses of selling corn. For instance, a farmer who expects to produce 80,000 bushels in August may hedge 40 percent of the produce on February 5. This makes 32,000 bushels in total. Hedging 40 percent of the crop means that the producer minimizes risk and exposure to price fluctuations. Thus hedging limits risk but does not eliminate it altogether. If the producer chooses to hedge 100 percent, then he will minimize risk entirely. The problem is that he will also lose the opportunity to profit in case of price increases.
Different Tools That Traders Use
Traders use different instruments such as limit orders, stop orders, and market orders. A limit order, for example, is a tool that enables sellers to set a minimum or limit price and the buyer to set a maximum price. The price is fixed until the order expires or is canceled or executed. Traders place a market order when they choose to sell or buy at a certain price. A stop order is placed when prices reach a certain level. Then the stop order works as a market order. It is also known as a stop loss order. There are different ways to exit the futures market – holding the contract to expiry, rolling the position, offsetting the position, and others.
Reference: Oil Futures: http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
Natural Gas Futures: http://www.investing.com/commodities/natural-gas
Tools for Beginners: Simulated Trading
A good starting point is to practice with simulated trading. You can use a simulated trading account to place a market order and stop an order, exit an order, or cancel orders. There are different trading stimulators available, allowing users to gain valuable experience. Customers benefit from hedging simulators and real-time analysis and quotes. Users can choose from two roles – the seller’s and the buyer’s. They learn about options and futures and different ways to deal with price fluctuations and to minimize risk. They can choose from different commodities, including natural gas, unleaded gasoline, crude oil, T-bills, Eurodollar, corn, wheat, and other grains. With simulated trading, traders can use other commodities and instruments, including metals such as palladium, copper, silver, and gold, and crops such as cocoa, soybean oil, soybeans, and coffee. Finally, instruments also include dollar indices and currencies (e.g. S&P 500).
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