Future contract trading
A futures contract allows traders to speculate on the price movement of commodities, currencies, stock market growth and other assets. Consider the fluctuations in the price of a commodity like gold. A futures trader profits by anticipating the direction gold prices will move. To understand, futures trading and futures markets we can consider one of the earliest forms of future trading in the past.
In the 18th century Japan, rice was a key part of the Japanese economy and functioned like a currency. Merchants would often pay warriors such as samurais for their support so that they may protect them or return the favour. The system worked perfectly fine till rice prices started to decline due to a result of several good harvests, the purchasing power of rice would decrease significantly and was not considered a valuable commodity. To resolve disputes, a futures contract was established. This involved a speculator which got involved and both the rice merchant and the samurai would be allowed to buy and sell rice for a fixed price on a future date. This cut risks for both parties and the risk of price change was eliminated.
From a trader’s perspective, assume the trader had one futures contract to purchase 100 ounces of gold at the price of $1000 per ounce in a span of 4 weeks. Suppose the value of gold in the market has increased by $10 for each ounce, making it $1010 per ounce. This increases the trader’s value of investment because the terms of the trader’s contract allows them to sell gold at a price below market value. This gives you a profit of $1000 if you sell 100 ounces of gold at $1000 per ounce, since there is a $10 additional value and multiplying this value by a 100 gives you a $1000.
Buying futures is different from a stock or an option. When you purchase a futures contract, you are not required to pay a large payment upfront. Instead, you are required to keep money in your account to fill the margin requirement. The margin requirement is only a small percentage of the value of an underlying asset. It is intended to be enough to cover the likely maximum one day loss from changes in price to the value of an asset specified by the futures contract. At the end of each trading day, this money is used to settle any gains or losses from your investment
For example, suppose a trade moved against you one trading day. At the end of that day, money would be removed from your account to cover the losses from your futures contract. If the loss was significant and enough money was removed and your account no longer had enough cash to cover the margin requirement, you would find yourself in a situation known as the “margin call”. What happens during a margin call depends on your broker. You may be required to deposit additional funds to cover the margin requirement or your trade will be automatically sold.
With a futures contract, a small investment can lead to big profits or big losses. This is because a futures contract is a leveraged investment. In investing, leverage is ability to control a large amount of money with a small investment. Futures contracts are highly leveraged. Because of this, small changes in the price of the underlying asset have a much larger impact on a futures contract. This is one reason why investing in futures is much riskier than other investments.
So how can you use leverage to your advantage? Leverage is a valuable ally when investment is used as a hedge, a way to protect your portfolio. While a leveraged investment can be useful when used as a hedge, you take on an extreme amount of risk when it is your only position in the absence of bonds and stocks and this could wipe out your entire portfolio.