A futures contract is a "legal agreement to sell or buy a certain commodity asset, or security at a predetermined price and at a specified time in the future." While it may seem like a complex financial realm, futures trading offers the potential for flexible income generation to financially disciplined retirees desiring ways to expand their income base.
It is essential to understand the key terms and concepts that make up the activity to be successful in futures trading. Understanding trading concepts such as margin and long and short positions helps the trader make informed decisions and wise investment choices.
The first concept to understand in futures trading is "long vs. short positions." Traders take a short position in a futures contract when they sell an asset they don't own while expecting the price to fall in the future. How does it work? If the price of the involved asset falls at the contract expiry time, they buy it at a lower price than they already sold it. The profit comes from the difference between the cost and the selling price.
On the other hand, traders take a long position on a contract when they predict that the value of an asset will rise. They buy the asset to resell it at a higher price than they bought it. The risks involved in taking either of the two positions are different according to the commodity. Usually, short position traders are at greater risk since there is no limit to how high an asset's price can rise.
Another concept in futures trading is the system of margins. Instead of paying the full price for an asset when buying, a trader can put up only a fraction of the cost price, called a margin. Margins allow traders to leverage large market gains affecting their assets. However, margins can also cause huge losses for traders if market conditions turn unfavorable.
For instance, if a trader wishes to buy a futures contract for gold at 1,000 dollars per ounce while a single futures contract controls 100 ounces, she will need 100,000 dollars to buy the gold outright. But if the market allows a 10 percent margin system, she will only need to pay 10,000 dollars down ahead of the contract expiry date.
In futures trading, the delivery date refers to the agreed date when the buyer assumes ownership of an asset (in physical settlement) or when cash settlement occurs. Physical settlement in futures contracts is less common but still exists for commodities such as oil and agricultural produce. On the delivery date, the seller delivers the assets to the buyer.
Cash settlement does not involve the exchange of products. It is common in trading financial instruments like currencies or stock indexes. In cash settlement, the seller will pay the buyer the difference if there is an increase in the asset price from the price agreed on in the futures contract. If the price drops from the price in the futures contract, the buyer settles the seller with the price difference.
Hedging is a concept in futures trading that helps investors manage risks in existing investments. For instance, a shareholder in a company could be worried about the company's falling share prices. If that shareholder acts on that concern and takes a short position in a contract involving that company's shares (that is, she sells a futures contract at a high price) and the price indeed falls, she can offset her loss from her shareholdings with the profit she makes.
Futures traders act like speculators, betting on the pricing patterns of assets and making decisions to take a short or long position based on their betting and analysis. Speculators' success depends largely on volatility.
Volatility refers to the degree of price fluctuation in a futures market. A highly volatile market sees frequent and significant price changes, which present the potential for profit and the risk of substantial loss. A market with low volatility has more stable prices, allowing for more controlled predictions of the market movement.
The concepts and terms mentioned here are only some basic terms to understand in successful futures trading. Brokerages and financial literacy institutes offer glossaries and courses for further learning. Many of these institutes also offer trading simulations to help beginners practice before trading with real money and assets.
