What To Pay Attention To When Buying Futures Contracts
In the diverse world of investment options, futures contracts are becoming more popular than ever. Originally developed from forward contracts – which were used by commodity producers like wheat farmers to lock in an agreed-upon price for the wheat they’d be harvesting many months later – futures contracts were designed and developed to help reduce the risk involved. With a contract, anyone who invests in futures is protected if prices drastically drop. Today, futures contracts – often referred to simply as “futures” – are used by a wide range of people and have many pros and cons associated with them.
Futures Contracts: The Basics
A futures contract is an agreement – which is legally binding – to purchase a commodity on a specific date in the future for an agreed upon price. This price is referred to as the futures price. Futures contracts are considered to be safer than many other investment products because they are based on a set of specific, standardized terms. The terms imposed by a futures contract may include:
• Settlement Type – Usually either a physical settlement or a cash settlement
• Underlying Asset – Could be a bushel of corn, an interest rate or a financial instrument like gold
• Currency – The specific currency of the futures contract is quoted
• Unit Type And Amount – Under the contract, the specific unit the underlying asset is being traded in is clearly outlined, as is its total amount
• Grade – The grade, or quality, of the underlying asset is explicitly spelled out and must be delivered as such upon the delivery date or final settlement
• Other Details – Many other details, including delivery month and the last trading date, can be spelled out under a futures contract depending on the underlying asset
Whether or not futures are an appropriate vehicle for a specific individual depends on many different things.
Why People Trade Futures
To get a better understanding of why futures are traded, it’s smart to be aware of a few examples. Someone might choose to purchase a futures contract if he expects the price of a stock to increase within a particular period of time. In this case, he would be using a speculative form of futures trading.
How Futures Prices Are Determined
The price of security futures is determined in the same way that stock prices are: the continuous fluctuations associated with supply and demand between buyers and sellers. Therefore, volatility can be quite high in futures contracts. As a buyer, you would benefit in the event that a futures price increased; you would lose out if the futures price decreased. For example, if you expected the price of the stock for EXAMPLE corporation to increase and purchased a 100-share April futures contract at $60 per share – and could later sell it at $70 per share – you would make $1,000 on the contract.
Understanding Margins
When it comes to futures contracts, a margin refers to the money that must be kept in an account to cover potential losses; by law, it is 20% of the contract’s value. Some people call it a “performance bond.” Depending on fluctuations, additional funds may become necessary; such a situation is known as a margin call. There is no guarantee that you will make enough on any futures contract to cover your margin or any subsequent margin calls.
How To Get Into Futures Trading
There are three basic ways to break in to futures trading; they are outlined below.
On Your Own – This is the least recommended method, as the volatility of trading futures contracts can lead to major trouble. If you decide to go it alone, it is best to only do so after “learning the ropes” through one of the other two options.
Managed Account – A safer way to get into the volatile futures trading market is by opening a managed account, which is similar to an equity account. A broker trades on your behalf, based on agreed-upon conditions.
Commodity Pool – Another, safer way to get into futures trading is by joining a commodity pool. Like a mutual fund, a commodity pool consists of commodities that can be invested in and shared among a group of other investors. The risk is mitigated a bit, because it is spread out.
Tips Regarding Futures Contracts
When using futures contracts, it’s important to note:
• You must be willing and able to meet the requirements of any potential margin calls; in other words, you must have access to additional funds at all times
• You must be willing to closely monitor your open futures positions; a sudden change might precipitate the liquidation of your contract
• While it is possible to make an excellent profit on buying futures contracts, there is also great risk of losing a lot of money
• As a general rule, the bare minimum that should be in an open futures account is $5,000; however, $25,000 or even $50,000 is a much more reasonable, realistic amount.
