what is futures trading? with simple examples

What is futures trading: betting on the future (in simple terms)

Futures trading can seem complicated at first, but when it's broken down, it's easier to understand. In this article, we will explain in simple terms what futures trading is, how it works and why people participate in this type of trading.

Understanding futures trading:

Futures contracts are contracts between two parties to buy or sell an asset at a predetermined price at a specified time in the future. This asset can be anything from commodities like oil, wheat or gold to financial instruments like stocks or market indices.

This style of trading can also be found in financial markets such as forex, digital currencies and other markets. This tool allows traders to execute trades in the present, but the maturity date of the contract is in the future.

In simple terms, the buyer and seller of a product agree to trade a product at a certain price in the future, regardless of whether the buyer or the seller made a profit or a loss, you must stick to your commitment and when the contract expires make a deal .

Let's break down futures trading with an example:

Imagine you are a farmer planting wheat. You are worried about the drop in wheat prices at harvest time. To protect yourself, you can enter into a futures contract with the buyer.

Contract: You agree to sell 5,000 bushels of wheat to a bakery on December 31 for $5 per bushel.

Futures: This contract locks you in today's wheat price, regardless of what the market price is on December 31st.

Scenario 1: Wheat prices rise to $6 per bushel by December 31. You've locked in a lower price, but you're still happy because you've secured a sale.

Scenario 2: Wheat prices fall to $4 per bushel by December 31st. You have protected yourself from harm. Even if the market price is lower, you are still obligated to sell at $5 per bushel and ensure a profit.

Key points of futures trading:

Contract: Futures include a legally binding contract to buy or sell an asset at a specified price and date.

Future Price: You are betting on the future price of an asset.

Leverage: You do not need to own the underlying asset to trade futures contracts. This can increase profit or loss.

Margin: Futures often involve margin, meaning you don't have to pay the full price of the asset upfront. Instead, you pay a percentage (known as margin) as a deposit. This allows traders to control larger amounts of assets by paying full price, giving them more buying power (or leverage).

In this situation, as a trader, you deliver the amount as a guarantee to the employer, and in return, you can borrow a large part of your trading capital from the stock exchange.

Then you can make a transaction with that total amount. Such a position will be useful for you. That is, the profit you get is equal to the entire position you opened.

Of course, this method has its own risks. As much as you can gain in this method, there is just as much potential for loss.

Leverage is not a concept specific to digital currencies. This tool allows traders to make trades with a volume that exceeds their original capital. Another name for this trading style is margin.

Where do exchanges get the capital needed for lfutures trading?

In traditional markets, this capital is provided by the brokerage itself. But the capabilities of digital currency allow exchanges to provide this liquidity with the participation of other users. One of the common ways to provide the necessary liquidity is to create investment pools.

People who intend to keep their capital in the stock market, by referring to such pools, earn profit by locking their capital, and in this way, their capital is used to provide the capital needed by contractual traders.

They do not risk losing their capital, because in leveraged trading, the exchange will not allow the loss to reach the amount of capital lent.

Settlement: When the contract expires, there are usually two ways to settle it:

Physical Delivery: Physical assets are exchanged. This is common with commodities.

Cash Settlement: The price difference between the contract price and the current market price is exchanged for cash instead of the actual asset.

Risk: Futures trading involves significant risk as prices can fluctuate widely.

Important note: futures trading is complex and involves significant risk. It is important to understand the risks involved and seek professional advice before entering into a futures contract.

Why futures trading? Potential benefits and risks

Futures trading can be attractive for several reasons:

Leverage: You can control a large position with a smaller amount of money.

Diversified Options: Futures are available on multiple markets and allow you to trade multiple assets.

Hedging: You can protect against price changes by locking in prices.
Companies such as farmers or oil producers use futures contracts to hedge against price changes.

A farmer can lock in the price of his crops before the harvest season. If prices fall later, they protect themselves against losses.

However, there are risks:

Market Volatility: Prices can change quickly and lead to potential losses.

Complexity: Understanding futures contracts and their strategies may be challenging for beginners.

Who trades futures contracts? A brief overview of market participants

The futures market attracts different types of participants:

Hedgers: These are usually businesses that want to protect themselves against price fluctuations. For example, a farmer might sell futures contracts to lock in the price of grain before harvest.

Speculators: Traders who intend to profit by betting on price changes.
Many traders use futures contracts to speculate on price changes. If you think the price of oil will rise above $70, you can buy the contract. If the price goes up, you can sell the contract for a profit.

Arbitrage in future trading

Arbitrageurs: People who exploit price differences between markets.
Arbitrageurs look for opportunities in different markets, buying in one market and selling in another to profit from the differences.

Key features of futures contracts

Standardization: Each futures contract follows a specific format for quantity and quality.

Liquidity: Many contracts are actively traded, making it easy to buy or sell when needed.

Margin Required: Traders only need to deposit a fraction of the total contract value.

Types of futures contracts

Future contracts are divided into different categories, which include:

Commodity futures: includes grains, energy and metals.

Index Futures: Linked to financial indices such as the S&P 500.

Currency futures: focused on foreign currencies.

How futures work: a step-by-step explanation

Opening a position: You enter into a futures contract by buying or selling.

Contract Hold: You can keep the contract until the expiration date.

Closing the position: Before expiration, you can close the position or wait until settlement.

How to Trade Futures: A Practical Guide

Opening a future account

To start futures trading, you must:

Choose a broker: Look for a broker that offers good trading platforms and resources.

Choose the type of account: Make sure the account matches your trading style and capital.

Entering futures trading

Order Types: Learn about market orders, limit orders, and stop orders.

Execution: Know how trades are executed in real time.

Risk management

To protect your investments:

Stop Loss Orders: Place a trade to limit the loss.

Position Size: Risk only a small percentage of your capital per trade.

Diversification: Spread your investments across different contracts to minimize risk.

Futures fees and regulations

Commission fees and other transaction costs

When trading futures, keep the following in mind:

Commission Fee: Fees that brokers receive for making trades.

Margin Fees: Additional fees associated with the use of borrowed funds.

Regulatory oversight of futures trading

Futures markets are regulated to ensure fair trading practices and protect investors. Regulatory bodies monitor business to prevent fraud.

Tax implications of futures transactions

Profits from futures transactions may be subject to certain tax provisions. Understanding how taxes apply to your business activities is essential.

Conclusion: Is futures trading right for you?

Futures trading involves engaging in contracts for the future delivery of assets. While it offers potential benefits, it carries many risks.

If you are checking futures contracts:

Educate yourself on concepts and strategies.

Choose a broker that meets your trading needs.

Start with a demo account to practice before real capital.