Interested in investing your money in Stock Markets; heard from people about the word Futures Trading in Stock Market, but not aware of its usage, then this article is just for you, jump in and get aware;
What is Futures Trading?
To understand futures trading, you must first comprehend derivatives trading. Derivatives are basically financial contracts whose value are based on the movement of the price of another financial item. A derivative’s price is linked to the price of another asset (the underlying) from which it derives its value.
A futures contract is a financial instrument where a buyer (the one with the long position) and the seller (the one with the short position) sign a contract or agreement in which the buyer commits to acquiring a derivative or index at a fixed price at a future date.
The price of the contract changes over time in relation to the set price at which the trade was made, which results in profit or loss for the trader. Every such contract is monitored by the stock exchanges who settle this trade and stock exchanges.
What is a Future’s Market?
A Future’s Market is a bidding market wherein the trader’s purchase and sells their commodities and futures contracts for delivery on a specified date in the near future.
Futures are exchange-traded derivatives contracts that guarantee the delivery of a commodity or security in the future at a price that has been determined today.
Some of the Future Markets are the New York Mercantile Exchange (NYMEX), the Kansas City Board of Trade, the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), Chicago Board Options Exchange (CBOE) and the Minneapolis Grain Exchange.
Futures market exchanges earn revenue from actual futures trading and the processing of trades, as well as charging traders and firm’s membership or access fees to do business.James Chen, CMT
How can you do Futures Trading?
Futures trading is primarily used for the purpose to hedge commodity price-fluctuation risks or to gain profit from price fluctuations rather than buying or selling the actual cash commodity, as is the case with stocks.
Stocks, indices, currency pairs, and commodities are among the four assets accessible for futures contracts.
Hedgers and Speculators are the two main participants in futures trading. Futures are used by hedgers to protect themselves against illogical or abrupt price changes in the underlying cash commodity in the future and are usually companies or people who deal in the underlying cash commodity at some point.
How can one Start Trading with Commodities Online?
In India, you can trade in futures on the NSE (National Stock Exchange) and the BSE (Bombay Stock Exchange). Now, let us understand the process of trading:
- Have a Thorough Understanding of the Working of Futures and Options:
Since the Futures is a financial instrument that is complex in nature and are non-identical from the stocks and mutual funds, therefore thorough understanding is required as it can prove to be a challenging task for a person who is trying to invest for the first time.
- Be Ready to Take Risks:
Since everyone investing in the stock markets looks for profits, you can also lose their money while working on them. Therefore, it is necessary for you to know that the amount of risk, you can bear with and should act accordingly and if neglected can affect your the daily life.
- Your Approaching Strategy to Future Trading:
Since you are new to the stock market working style, it is an important step to decide and have one strategy wherein you can buy or sell futures based on your own understanding and decision.
- Practice on Simulated Trading Accounts:
Once you know the working style, one should practice the same in a simulated trading account which is available online and should get a practical experience of the on-going future market. This method might help you in recognising mistakes and doing better in Futures trading.
- Open Your Trading Account:
After practicing in the stimulated accounts available online, you should make your own trading account and should make sure that a thorough background check has been done. One should choose the trading account which suit’s one the best and not go buying others opinion.
- Arrange a Required Margin Money
As stated above, a fraction of the amount i.e. margin money is required to be deposited as a security as it is essential part of a contract. Therefore, it is essential to arrange the marginal money required to purchase and take part in the futures trading.
- Deposit the Margin Money
When one has arranged for the marginal money, the next step which comes is to pay to the depositor in exchange. The exchange holds the money for the entire period of time until the termination of the contract. During this course of time, if the marginal money increases one has to pay and vice-versa.
- Place Orders with the Brokers
After the following above process, you can secure your order with the broker. This process is similar to the process of buying shares on the stock market. In this, one has to tell the size, quantity, the strike price and the expiration of the contract, after this, the broker will provide with contracts meeting one’s provisions and one has to choose from them.
- Settle the Futures Contracts
After the process of finalising your future contracts you need to settle them. This can be done earlier from the done either early from the expiration date or on that date. This settlement is nothing more than the delivery of the commitments prescribed in the Futures contract.
Since now you are aware of the procedure of doing Futures Contracts, it is important to understand the advantages as well as the disadvantages attached with them.
Reasons for Choosing Future Trading
Some of the reasons which back us for choosing Futures Trading rather than investing in Stock Market are:
- Futures are investments which are highly levered.
- Futures Market are highly liquid in nature
- The Costs for Execution and Commission are less as compared to that o Stock Markets.
- The Speculators can gain money at a faster rate.
- Futures are great for Diversification or Hedging Purposes.
- These markets are fairer and work in a more efficient manner.
- These contracts are only paper based investments.
- Investors can get short exposure to investing and in an easier form.
As stated above in the first point, Futures Stocks are highly levered, lets understand the meaning of leverage to understand the working of the Futures Market better.
What is Leveraging and Margins in Stock Market?
In Futures Trading, it is not necessary for the investors to pay the whole amount to buy, but only a small fraction of the total value is considered enough to buy or sell them. This amount is called margin. This value differs from stock to stock. From this marginal money, you can buy/sell more shares of Futures as compared to those with equity at the same amount of money.
Leverages are referred to as the use of debt i.e. borrowed funds to boost the returns on an investment or project. It allows the investors to increase their purchasing power in the market. Companies use debt to finance their assets—rather than issuing stock to raise capital, companies can use debt to invest in business operations in order to boost shareholder value. Leverages are considered to be double-edged swords, as it multiplies profits but also multiplies losses.
Disadvantages of Future Trading
- Since Futures have high leverage values they are quite risky in nature; one step if taken wrong can lead to large amount of financial damages.
- Since these stocks are complex in nature, understanding its working and its usage is difficult. It can be said that they are complicated products.
- There are price limits for commodities, which when reached limits the investors from investing further in that day.
- It provided large margin deposits to new investors which are too large to be handled for them.
Futures Trading has its pros and cons, it might attract due to its high leverage values and returns but that might be dangerous if not looked upon, here is a small recent case study where the danger of investing in Futures Trade was seen
A Case Study on the Futures Market rates of Texas Oil which went into Negatives during the Year 2020.
During the month of April last year, the prices of West Texas Intermediate (WTI) which is the American Benchmark for crude oil which is traded under the Futures Contracts under the NYMEX, had fallen into negatives in trade and had become notoriously volatile in nature. It had fallen to minus $37.63 per barrel, making us think that the payer buyers are thinking of getting rid of their crude oil.
Why Did the Fall in Price Take Place?
Since it is traded as Futures, the Speculators bought and sold contracts and had no intention to take or offer delivery of a physical oil on the contracted date.
It was on a day, when speculators who had bided for large bets on the ay Futures had started to unwind their positions of their contract because the contracts were set for expiration on that day. They did not have an intention to take physical delivery and therefore wanted to loosen themselves from the contracts before the date of expiration. This act could have led to the stupendous fall in the share price of this oil trading company. But there was a possibility that the traders who were based on delivery would have backed out from, their contracts due to the fallen demand for oil. Therefore, it can be said that the result was a combination of both categories.
It can be analysed and said that the reason for not getting physical delivery or the massive fall in the prices was the spreading of the COVID-19 virus around the world, as well as the price wars that have been taking place between the two big oil giants Saudi Arabia and Russia.
Since trading is quite a risk-taking method of making money, it involves making of profits as well as making losses, therefore, it should be done in a smart way and the investor involved should do frequent checks so that they can minimize their losses.
Lastly, to sum it up,
Future’s Trading can be summarised in three points:
- A contract has been made between two parties for the future with an expiry date.
- There are two participants: a) Hedgers b) Speculators
- The buyer gives a small fraction of money to the seller at the time of initiation of the contract.
Some of the Key points about Futures Trading are:
- These are contracts or agreements which is done between two parties so as to conduct a transaction at a pre-decided locked price at some point in the near future.
- The prices of futures are directly proportional to the stock value of the company.
- The main difference between the stock futures and pure cash market trading is the margin i.e. one need not pay the full stock price, but rather a small fraction.
Since everything has its advantages as well as disadvantages, Futures Trading also has some, but having clarity of its working and frequent check on their share prices and their news can make one’s investing better.