Futures are complex and volatile but also useful investments. In addition to the necessary financial resources, futures trading also requires emotional and financial temperament. Anyone thinking about trading futures contracts must fully understand the concept of leverage.

Futures are obligations to buy or sell a specific commodity — such as corn, gold, or Treasury bonds — on a particular day for a preset price. Futures contracts expire on a specific day each month and are dropped from trading. For example, US Index contracts expire on the third Saturday of the expiration month and can be liquidated or offset on or before the third Friday.

What are derivatives investments?

Futures belong to the group of financial products known as derivatives because their prices reflect, or are derived from, the value of the commodity underlying the futures contract.

Commodities can be consumable, such as sugar and wheat, or financial, such as an index or a particular stock. Futures developed from forward contracts, originally used by commodity producers — corn farmers, for example — to lock in the price they were to be paid for corn when it was harvested some months later.
With the contract in hand, the farmer was protected if corn prices dropped.

In addition, futures contracts formalized the forward-contract process, imposing standard contract terms for grade, quality, quantity, and delivery month. With the imposition of standard terms, it became possible to trade futures contracts on an organized exchange, creating a futures marketplace.

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Buying or selling a futures contract does not transfer ownership. Instead, the contract spells out the terms of the deal, including the rights and obligations of the buyer and seller, the underlying product — also called the underlying instrument or just the underlying — to be purchased or sold, the quantity, and the timing.

What does leverage mean in Futures trading?

Leverage, in financial terms, means using a small amount of money to control an investment of much greater value. For example, futures contracts are highly leveraged instruments. Under most circumstances, you can buy or sell a futures contract with a good faith deposit called an initial margin, which is a percentage of the underlying item’s value, often 10% but 20% for a security future.

Futures: Setting Expectations

For example, if you buy a gold contract worth $125,000 when the futures contract represents 100 ounces of gold and the gold futures price is $1,250 an ounce, the required good faith deposit might be $12,500. That gives you 10-to-1 leverage since you control the $125,000 investment with your $12,500 deposit.

As another example of how leverage affects the value of a futures contract, consider a situation in which the price of the commodity underlying a contract increased $30, $40, or $50 per unit within a short period. If the price went up $50 per unit and the contract covered 100 units, the value of the contract would jump to $5,000. But, of course, the opposite could also happen. If the price per contract unit dropped $50, the value of the contract would drop $5,000.

So while leverage means that the initial amount required to buy a futures contract, known as opening a futures position, is relatively small, changes in the market price of the contract are magnified in relation to your initial deposit.

High leverage can produce significant earnings compared to your original margin deposit if you speculate on futures contracts and the price moves in the direction you predicted. High leverage, however, might result in significant losses relative to your initial margin deposit if prices move in the opposite direction.

What are the risks of trading Futures?

Futures are complex and volatile, so they can make the investor vulnerable to massive losses, even for small movements in the market. Therefore, before trading futures, investors should plan and conduct their research and be aware of both the benefits and risks.

Below are the risks associated with trading futures contracts:

  • Leverage is a two-edged sword since it gives the capability to make profits as well as lose quickly. On the other hand, you may leverage more and thus stand to lose more money because the margin requirements for trading futures are low.
  • Interest rate risk. Since interest rates are also a part of the futures price, the gap between futures and spot prices increases when interest rates rise. So you could get into trouble if you are short on futures.
  • Price risk. If you buy futures, you expect the price to increase; otherwise, you risk losing money. The negative fluctuation of prices poses the greatest risks for futures traders.
  • Volatility. Futures exchanges monitor and act to control price volatility. In most cases, the exchange where a futures contract is traded establishes a daily price limit that prevents the price of that particular contract from rising or falling beyond a preset limit. As a result, volatility risk is sometimes overlooked as one of the key risks of trading futures.

Typically, you set a stop loss while trading futures. But when markets are overly volatile, futures trading’s risks are increased because the price may hit the stop loss and then move in the direction you want.

Why trade Futures?

Individual investors and traders most frequently use futures to predict how the underlying asset price will change in the future. By speculating on the future direction of the market for a certain commodity, index, or financial product, they hope to make money. Additionally, some investors utilize futures as a hedge to reduce the impact of potential future market changes in a particular commodity on their portfolio or company.

Typically, futures contracts are traded only on the exchange that lists them rather than on multiple exchanges as securities are. The listing exchange develops a contract’s terms and conditions, provides speedy clearing and settlement of trades and ensures that obligations to buy or sell are met. Similar or even identical contracts may trade on more than one exchange, but one contract on a particular commodity usually dominates the competition in trading volume and liquidity. In other cases, an exchange may have the exclusive right to list contracts on a specific commodity.

By using your knowledge and speculating on future prices, futures contracts are an excellent way to diversify your portfolio and guarantee you make good profits. You can use a futures contract to effectively hedge your losses in other asset classes and take delivery of the underlying asset before the expiration date because futures trading can be done on various underlying assets.

Understanding Leverage. Are Futures Risky? by Inna Rosputnia

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