Trading with leverage
Futures are one of the most popular leveraged instruments – primarily among commodity traders. Find out how futures work in this lesson.
- What is a futures contract?
- How does futures trading work?
- Futures trading example
- What markets can you trade with futures?
- How to trade futures
What is a futures contract?
A futures contract is an agreement by one party to take delivery of an asset – normally a commodity – at a specified future date for a pre-determined price.
A futures contract has a date attached to it. This means that at the end of that given month, the holder of the contract is obliged to take delivery of that asset – e.g. a barrel of oil – at that price.
Futures can also be used to speculate on assets.
- If you think an asset’s price is going to increase, you can select a lower price to buy at. If the market rises, you’ll be able to purchase it at the cheaper price
- If you think an asset’s price is going to fall, you can choose a higher price. If the price falls, you can close your contract by selling at the more expensive price
Futures were invented to guarantee the price of goods in the future, reducing the risk of prices changing. That’s why you’ll likely have heard of their use in the agricultural industry, where buyers and sellers of commodities want to fix the price of crops in the future.
But speculators now make up most of the futures market, using them as a means of betting on whether market prices will rise or fall. Instead of having hundreds of barrels of oil turning up at their house, traders settle each futures contract in cash.
Like other derivatives, futures are leveraged, offering the potential for outsized gains or losses.
How does futures trading work?
The way futures work depends on whether you’re trading them on an exchange or directly with another party, more commonly known as over the counter (OTC).
When you trade futures on exchange, you’re entering a centralised marketplace where the contracts are standardised for both quantity and quality. They will also have set expiry dates – you can choose which maturity to trade, but you can’t set a date yourself.
For example, an oil futures contract trading on the New York Mercantile Exchange (NYMEX) will consist of 1000 barrels of West Texas Intermediate (WTI) oil of a particular quality.
If the current price of WTI futures is $70 per barrel, then the value of the contract is determined by multiplying the current price by the size of the contract. Here, the current value would be $70 x 1000 = $70,000.
As futures are leveraged, you’d only have to pay a percentage of that cost to open the trade.
Futures traded off exchange are known as over-the-counter contracts or forward contracts. They’re traded directly between two parties without an intermediary, this means they’re not as highly regulated and don’t have the same standardisation as exchange-traded futures.
OTC trading can create the risk of counterparty default – where one or both parties fails to uphold their side of the contract.
Future trading example
Let’s say you’re a food producer, and you want to make sure you can buy wheat at the current price – known as the spot price – of $200 per tonne, but in three months’ time. This would ensure your profit margins in case the price of wheat rises during those three months.
By purchasing wheat futures contracts, you know you’ll be able to take delivery of the wheat at $200 per tonne, regardless of whether the spot price rises. If the price of wheat rose to $250/tonne, the contract continues to give you the right to take delivery at $200.
The only downside is that if the spot price of wheat is cheaper after three months, you’ll have to buy expensive wheat – but that’s part and parcel of the deal.
What futures markets can you trade?
Mostly when we talk about futures, you’ll be thinking about commodities. The reason futures began trading in the first place was to allow farmers to sell their grains. Not much has changed. The most-traded futures markets are all commodities: crude oil, corn, natural gas, soybeans, and wheat.
The market prices you’ll see for commodities are all normally taken from futures contracts too. For example, even our spot price is calculated using the price of the two nearest futures contracts at any given time.
Stock index futures
Futures can also be used to take a position on stock market indices.
As an index is nothing more than a number representing a group of stocks, index futures form the underlying price that other derivatives – such as CFDs – track.
You can even trade index futures when the market is closed. For example, futures on the Dow Jones Industrials index start trading in Chicago well before the actual New York market opens. It’s common to see traders checking the price of index futures before the market opens as a gauge for what prices will be.
How to trade futures
We offer futures trading via CFDs, where you’ll speculate on whether the price of a futures contract will rise or fall within a given expiry month.
These have the advantage of not requiring you to take delivery of an asset when the contract matures, but rather you can settle in cash or roll the position over into the next expiry.
Put your knowledge to the test
Practise trading futures via spread bets and CFDs in a risk-free demo