Futures 101: Futures Trading Explained

What is Futures Trading?

Futures trading differs from transactions in the underlying cash market in that futures transactions are conducted on an exchange. An exchange is an association of members. The exchange does not trade or own commodities. It simply provides a facility where buyer and sellers can trade and makes sure that this process goes smoothly and fairly.

These buyers and sellers do not have personal contact with one another. An exchange’s clearing house acts as a buyer to all sellers and a seller to all buyers, in that it matches bids to asking prices. The exchange also standardizes contract sizes and grades to ensure fairness and instill trust in the product among the buyers and sellers.

Neither the buyer nor seller is locked into the obligation to make or take delivery. They can eliminate the position with an offsetting transaction so long as this is done before expiration. (Delivery is actually a very rare occurrence in the futures market, as traders can enjoy the benefits of the futures market without actually holding the contract until it expires and fulfilling the obligation to accept or deliver the goods.)

A seller offsets a position by buying back an equivalent contract on the same exchange. Conversely, a long position can be offset by selling an equivalent contract on the same exchange.

What Exactly is a Futures Contract?

A futures contract is an agreement to either make or take delivery of a specific quantity and grade of an underlying commodity at a future date and price. The buyer, or “long” position, agrees to take delivery of the underlying “cash” commodity (or other product) and pay the seller for this right. The seller, or “short” the position, agrees to deliver the underlying cash commodity in return for the contract price.

What are the Benefits of Trading Futures?

Leverage: Futures offer high leverage, meaning you can control a lot of money with very little paid down and low margin requirements. But know that futures are a zero-sum game—for every winner there is a loser, and just as your profits are compounded by leverage, so will your losses be.

Flexibility: Because futures are available for both nearby contract months and far deferred months, they are useful for both short- and long-term traders. The hours of operation for the futures market also makes them appealing to both full- and part-time traders. Electronic futures markets are available nearly 24-hours each weekday.

Hedging: Futures allow producers and users of a commodity to hedge their risk or lock in profits should prices move against their stake in the underlying market.

Alternate market: Futures provide another option for producers or users looking to buy or sell a cash commodity if the cash market price is undesirable. And if you are interested in the currency market but wary about getting involved in this less regulated and transparent market, forex futures might be a good option. Though not as heavily traded as the forex market, most futures markets are still quite liquid.

Benefits for the pocketbook: If the futures contracts you are trading fall under the commodities category, they may offer advantages come tax season. Commodities enjoy the 60/40 rule, meaning capital gains/losses are split with 60% of them being taxed at the long-term 15% rate and 40% at the short-term ordinary income rate of up to 35%. This does not apply to futures classified as securities or single stock futures. Trading in the futures market also offers low commissions relative to other investments.

Information-rich: There is no shortage of market-moving data in futures— government policy, economic data, weather conditions, supply-and-demand related reports, and many more all have the ability to move the futures markets. It is in filtering through this information and understanding how market participants will react that skill comes into play.

Want to learn more about Futures Trading or check out Futures Trading investment strategies? Give our office a call today 1.800.883.0524.

 

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