Trading is a widespread practice in stock markets worldwide. A practice of buying and selling financial assets that are termed as stocks or shares in the share market arena, trading has been practiced by millions of investors from all around the world and continues to be used as a money-earning opportunity.
With professional courses and auxiliary coaching, investors trade in the stock market to earn quick money based on their investment instincts and the prevalent market profitability.
From beginners to experienced professionals, almost everybody is intrigued by the way a stock market runs and benefits its buyers and sellers. A world of money and numbers, the stock market is not a child’s play.
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Yet, it can be understood well with gradual learning and regular practice. Since money is the key factor in this scenario, profit and loss are inevitable to a trader. What’s more, risks are also indispensable considering that the stock markets rise and fall every day.
As many of you might be aware of prevalent terms in the stock market era, we are here to unfold another concept - Futures Trading.
In this blog, we will learn about Futures Trading, how it works, the main characteristics of the concept, and some of the well-known pros and cons of this practice.
To begin with, Futures Trading is a legal trading practice that involves the buying and selling of a financial asset of a stock at a predetermined value and a specified time in the future.
As the name itself suggests, the trading of a futures contract takes place in the future between two parties - buyer and seller. This trade is arranged by a broker and the two parties are usually unaware of one another’s existence.
A key highlight of this concept is that a financial asset (commodity , currency, or interest rate) is traded (bought and sold) in the future at a predetermined price that is decided in the present.
With reference to the leverage an asset provides, whether long call or short call, the two parties arrive at a predetermined price and a future date that is finalized for the buying and selling of a financial asset.
The price is deemed to be final regardless of the future market condition and stability. That said, there are a number of features of futures trading.
Broadly, there are a number of types of futures contracts that are traded in the contemporary world - commodities futures, currency futures, interest rate futures, and stock market futures.
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How does it work?
Like any other derivative trading (contracts that derive their value from the movement of another financial asset), the futures contract is also a trading practice that takes place between a buyer and a seller.
Only certified members of an exchange are allowed to trade in futures contracts that are overseen by a clearinghouse and mediated by a broker or a middleman.
In order to fix a predetermined value of a futures asset and set a maturity date for the same, a mathematical model is taken into use. This model computes the current asset prices, risk-free rate of the underlying asset, maturity time period, and dividend yields of the contract.
As stated earlier, the predetermined value of the asset does not change. However, the daily gains and losses reflected by the market change lead to profits on the end of either the buyer or the seller.
This can be caused by the regular volatility or fluctuation in the market scenario. Here is a futures trading example.
“An oil producer needs to sell their oil. They may use futures contracts to do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires.” Commodities Futures Trading
Features of Futures Trading
In this segment, we will be highlighting the key features of futures trading that will help us to better understand the way the concept works and what is included in the system of trading futures contracts.
Unlike forward contracts that have terms and conditions set by the two parties, futures contracts are standardized trading practices that are organized and standardized in nature and supervised by exchanges.
Under the system of futures trading, the trading practice takes place in a physical location where both parties are present at the time of exchange.
The terms of trading like the value of an asset or commodity and maturity date are finalized after the two parties agree on such terms.
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In a way, this practice is standardized and involves the say of both the parties in accordance with the prevalent situation of the market. The importance of a clearinghouse in this concept is quite prevalent.
Since it is a legal trading contract, it also includes a clearinghouse or a supervising organization of the exchange within which the futures contract is held.
One of the futures trading basics involves a clearinghouse in a futures contract that validates and approves such a trade while ensuring that both the parties of a contract abide by the terms and conditions.
Among the features of futures contracts, the concept of margin and marking to market are very prominent.
Before a futures contract is fixed upon and its maturity date is derived, a margin is put on the contract that serves as collateral or security for the same. To trade futures, an investor (buyer and seller) has to pour in a minimum of 10% of the asset value in order to assure their participation in the trade.
This margin is deposited with the futures trading brokers or the exchange company as a security if in case the contract incurs losses on either of the parties of a futures contract.
Marking Futures to Market
The third feature of futures trading is marking the contract to market. Marking to Market in futures or MTM is a concept in the futures trading system wherein market fluctuations of each day are marked to the asset.
What this means is that a rise in the value of an underlying asset of a futures contract leads to a gain of the buyer, and inversely, a dip in the value of the underlying futures contract leads to a gain of the seller.
Simply put, marking to market margin refers to the settling of gains and losses of an underlying asset due to the changes in the market value of the asset.
Even though the maturity value of the asset remains fixed throughout the contract, the futures asset is market to market on each day that can lead to gains and losses on the part of either the seller or the buyer.
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Pros and Cons of Trading Futures
As we have already understood the whereabouts of this concept, let us now move on to discovering the pros and cons of futures trading.
Pros of Futures Trading
Low Margin Criteria
As compared to other derivative contracts in the stock market exchanges, futures trading offers a low margin criterion that can be afforded by a vast number of investors.
This allows investors with comparatively low capital to invest in futures contracts.
Safer Trading Practices
Unlike forward trading that is a private trade practice between the buyer and seller, futures contracts are overseen by clearinghouses and exchanges that set standards for the trading.
This ensures that futures trading is a safe trading practice with legal provisions in place.
High Liquidity of Market
Futures trading allows high liquidity assets to be traded, implying that investors can pull themselves out of the contract at any point of time until the maturity date.
Traders can also enter into these contracts according to their wishes, which is a significant advantage.
Cons of Futures Trading
High Uncertainty levels
One of the biggest disadvantages of futures trading is that it has high uncertainty levels. The stock market is an uncertain place wherein gains and losses are inevitable.
Perhaps a high uncertainty level of asset value is a major drawback of futures contracts.
Potential Fluctuation in the future
Another one of the biggest drawbacks of futures trading is that the system is prone to potential fluctuation in the future, leading to financial risks.
Since the value of the underlying futures asset is predetermined at the current market price, it can change considering that the maturity date of the contract can be open to a different market price.
In comparison to other stock market concepts and just stock trading in the day-to-day world, futures trading is a much more complicated practice that requires in-depth understanding and extensive research of the way it works.
To sum up, futures trading is a stock market concept that involves two parties - buyer and seller trading a financial asset in the future at a predetermined price and a maturity date.
The key highlights of this concept are a standardized system, putting up a margin, marking to market, and the participation of clearinghouses.
“Futures contracts are a zero-sum game. This means, if one party loses millions of dollars, the other party gains millions of dollars. Nevertheless, such contracts give investors another investment avenue to make big profits, as well as hedge risk.”