For many investors, the futures markets, with all of the different terms and trading strategies, can be both confusing and daunting. There are opportunities to limit losses on your portfolio or enjoy significant profits by using the futures markets, but it is important that you understand how these derivative products work and how you can achieve those profits consistently. This article explains how each market works and the different strategies that can be used to make money.
How Can You Be Successful?
The futures markets are where those hedging and those speculating meet to predict whether the price of a commodity, currency, or particular market index, will rise or fall in the future. Like any market, this one has risks when trading but the potential to see both short- and long-term gains can be substantial thanks in part to the huge amounts of volatility that these markets are known for having. Here are a few of the different futures markets along with different strategies that you can be used to profit from them.
A commodity is a physical product whose value is determined primarily by the forces of supply and demand. This includes grains, (including corn, wheat, etc), energy, (such as natural gas or crude oil) and precious metals like gold or silver, as well as many others
A commodity futures contract is an agreement to buy or sell a predetermined amount of the commodity at a specified price on a set date in the future. Like all futures contracts, commodity futures can be used to hedge or protect an investment position or to speculate on the directional move of the underlying asset. Individual investors can access commodities futures markets primarily through a managed futures account, available through specialized brokerage firms called Commodity Trading Advisors (CTAs).
Many investors confuse futures contracts with options contracts. With futures contracts, the holder has an outright obligation to act. Unless the holder unwinds the futures contract before expiration, they must either buy or sell the underlying asset at the stated price which is not the when purchasing options.
Currencies, or forex, trading involves looking to proift or hedge risk from the movement of foreign exchange rates and one commonly used strategy to trade currencies is scalping. Scalpers attempt to take short-term profits off incremental changes in the value of a currency. Doing this over and over again means that profits can continue to add up over time, giving significant total profits when all small profits are added together.
In general, time-frames can be as short as under one minute or may last several days. A scalping strategy requires strict discipline in order to continue making small, short-term profits whilst avoiding large losses. A wide variety of currency futures contracts are available. Aside from the popular contracts such as the EUR/USD (euro/U.S. dollar currency futures contract), there are also E-Micro Forex Futures which are contracts that trade at 1/10th the size of regular currency futures contracts. There are also emerging market currency pairs such as the PLN/USD (Polish zloty/U.S. dollar futures contract) and the RUB/USD (Russian Ruble/U.S. dollar futures contract).
Different contracts trade with varying degrees of liquidity; for instance, the daily volume for the EUR/USD contract might be 400,000 contracts versus only 400 contracts for an emerging market like the BRL/USD (Brazilian real/U.S. dollar).
Currency futures are traded on an exchange and traders typically have accounts with brokers that direct orders to the various exchanges to buy and sell currency futures contracts. A margin account is generally used in the trading of currency futures; otherwise, a great deal of cash would be required to place a trade. With a margin account, traders borrow money from the broker in order to place trades, usually a multiplier of the actual cash value of the account.
Currency futures should not be confused with spot forex trading, which is more popular among individual traders and involves trading the actual price of the currency.
Another category of futures popular with investors are index futures, such as the S&P 500 index futures contract. However, each futures product may use a different multiple for determining the price of the futures contract. As an example, the value of the S&P 500 futures contract is $250 times the S&P 500 index value whereas the E-mini S&P 500 futures contract has a value of $50 times the value of the index.
Index futures are also available for the Dow Jones Industrial Average (DJIA) and the Nasdaq 100 along with E-mini Dow (YM) and E-mini NASDAQ 100 (NQ) contracts. Index futures are available for foreign markets including the German, Frankfurt Exchange traded (DAX)—which is similar to the Dow Jones—the SMI index in Europe and the Hang Seng Index (HSI) in Hong Kong.
Index futures are a way to get into a passive indexed strategy, by owning the entire index in a single contract, and with greater leverage than an ETF would provide. Both the New York Stock Exchange (NYSE) and Financial Industry Regulatory Authority, Inc. (FINRA) require a minimum of 25% of the total trade value as the minimum account balance.
However, some brokerages will require greater than this 25% margin. Index futures can also be used to hedge against large stock positions.
Interest Rates & Cycles
Futures contracts on interest rates are also very popular with cyclical and seasonal trading being two commonly used timing-based trading strategies. A cyclical trading strategy is implemented by studying historical data and finding possible up and down cycles for an underlying asset. As an example, two commonly used cycles for stock index futures are the 23-week cycle and the 14-day cycle. Studying the price trends associated with cycles has led to significant profits in the past for those skilled in this area
Seasonal trading, on the other hand, is when you attempt to trade the seasonal effects that take place in the futures markets. Historical data suggests that many markets, sectors and commodities trade at varying levels throughout the year and show similar patterns year after year. Being skilled in trading different seasonal trends has proven to be another effective trading strategy.
Trading Without Risk
Getting started in the different futures markets can seem daunting and one way you can learn as you go without putting any of your money at risk is to start paper trading. Paper trading is done by mimicking trades by yourself (or with a trading simulator) until you feel that you are comfortable enough to begin real trading.
A good way to start is by concentrating on the above listed areas as this will help build your knowledge as you go along without increasing your overall amount of risk. Then, as you feel that you have more confidence in these areas, you can try expanding into trading other types of futures.
Trading different futures markets can be very rewarding but also very challenging. For new traders, there are many different markets and strategies that can be used to be successful, including those discussed here. By doing research and making sure you understand how futures work, you will have the opportunity to enjoy potential success trading futures.
Chris Seabury has over 20 years experience in financial services and regularly contributes to the likes of Investopedia.com, Yahoo Finance and Google Finance