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A Guide to Futures Trading

A Guide to Futures Trading

Corn, wheat, cattle, coffee and orange juice-all basic products or commodities that eventually find their way onto our tables are traded on the futures market, where there is much money to be made (or lost) if you guess right on futures trading prices. There are also futures markets for metals, cotton, energy, foreign currencies, stock market indices and interest rates. Futures contracts are traded on exchanges like the Chicago Mercantile Exchange and the New York Mercantile Exchange.

A futures contract on commodities is an agreement to either deliver or receive delivery of a certain quantity of a commodity on a particular date in the future at an agreed price. Futures contracts are used as hedges to transfer the risk of price changes. A farmer who sells wheat may want to lock in a future price now, to hedge against the possibility of a drop in prices in the future. A bread manufacturer may buy futures if they think the price of wheat will go up before it is harvested.

Speculators provide the liquidity for the futures market. That's where you come in. You are trying to make money based on price fluctuations in the future. As a speculator, you would close out the futures contract before the delivery date and would not actually deliver or receive corn or cattle.

How can you invest in futures?

You can buy and sell futures contracts through most full-service and some discount brokers. Choose a broker based on the services you want and the commissions and fees you are willing to pay.

The US Commodity Futures Trading Commission explains that you can open an individual account, making all the trading decisions yourself or giving your broker permission to make trading decisions on your behalf. Or you could purchase a share in a commodity pool, similar to a mutual fund.

If you choose to make your own decisions, you would buy futures (go long) when you expect prices to rise, and sell (go short) when you think prices will decline. This allows you the potential to make money on any movement in commodity prices.

When you trade futures, you're making an educated guess about the direction prices will go. Nobody knows for certain whether a specific commodity, such as corn, will rise or fall in value. To help make the most informed guess, you'll need to do some research and have a good understanding of the commodities you trade. It's a good idea to look at both historical data for the commodities you wish to trade as well as current economic data that shows supply and demand. You'll also want to keep an eye on current events, since a drought in the Midwest or political instability in an oil-producing nation can have a dramatic effect on the price of futures.

What are the risks of futures trading?

There is no guarantee that a futures contract will rise in value, and at some point in time, you're going to have to sell it. Selling too soon could reduce the profit that you make from the contract if prices continue to rise. The bigger risk, however, is the risk of loss. The commodities that underlie the contract could be wiped out; for example, frost could wipe out the strawberry harvest that you own, rendering your contract worthless. In this case, you'll lose whatever money you spent to buy the contract.

Another major risk is leverage. Each futures contract represents a larger amount of the underlying commodity. This means that your loss could be much more than your original deposit. You can often buy contracts on margin, putting down only 5% to 10% and borrowing the rest from the brokerage. If you engage in this type of trading, your losses will amount to the full value of the contract, not just the small percentage that you put down.

When you trade in agricultural commodity futures you also face risks such as floods, droughts and freezes. Economic factors such as inflation, deflation, recession and government intervention also come into play.

There are mechanisms for limiting your losses. Stop-loss orders tell your broker to buy or sell a particular futures contract at the market price if and when it reaches a specified level. For example, if you buy a futures contract at market, expecting the price to rise, when the market price is $550, you could then place an offsetting stop order to sell at $540. This protects you from a price drop below $540 if things don't go as you planned. Be aware that stop-loss orders are not guaranteed; if there are no buyers willing to pay the strike price for your stop-loss order, your brokerage will sell the contracts at whatever price it can get.

Another way is to use spreads, where you buy one futures contract and sell another. You expect to profit from a change in the relationship between the purchasing price of one and the selling price of another. If you lose on one contract, you may be able to offset the loss with a gain on the other.

Are futures appropriate for you?

As a general rule, only sophisticated investors with the willingness to research and a fundamental understanding of commodities markets should consider futures. The high level of volatility and potential for significant loss makes these securities appropriate only for those with long-term investment time horizons and a high level of risk tolerance. Investors who are easily swayed by emotion or who fear losses should avoid futures.

Leveraged trading should only be considered by those who have the financial resources to withstand significant losses. Remember that you are responsible for the full face value of leveraged contracts, not just the percentage paid to buy them. This could lead to you losing other securities or even your home to pay for the losses.

If you're willing to do the research and accept the risks, trading futures can be a part of a long-term investment strategy. You'll need to pay close attention to these investments and it's a good idea to enlist the help of an experienced financial advisor who can help you understand the risks and potential for gains.

Image by: Lars Plougmann