Futures Trading 101: Understanding the Basics and Terminology
Futures trading can offer many advantages to the trader, such as lower transaction costs and greater liquidity. However, it also carries certain risks that must be understood before entering into a futures contract.
What Is Futures Trading?
Trading futures is the buying and selling contracts for a commodity or financial instrument at an agreed-upon price and date. The contract’s specifications are settled between the buyer and seller, typically through an exchange. This type of trading occurs in agricultural products, energy products, foreign currencies, metals, interest rates and stock indexes.
Terminology in Futures Trading
Before we discuss the process of trading futures, let’s look at some key terms used in the industry:
- Contract Size – The number of units (such as bushels or barrels) specified in a futures contract.
- Margin – Funds deposited by both parties of a futures contract to cover potential losses due to market movements.
- Initial Margin – The amount of money initially required for one party to enter into a position on a futures contract.
- Maintenance Margin – A minimum margin must be maintained in a futures contract position to keep it open.
- Tick – A unit of measure indicates the slightest price movement on a futures contract.
- Basis – The difference between the spot (cash) market price and the futures contract price.
- Long Position – An ownership stake in an asset bought with the expectation that its value will rise over time.
- Short Position – Selling an asset for immediate cash payment, expecting prices to fall over time.
- Delivery Month – The month specified in a futures contract when the goods or financial instruments underlying the contract are delivered and settled between parties.
- Settlement Price – The final agreed-upon price at which a futures contract is settled at the end of its delivery month.
- Open Interest – The number of open futures contracts traders own in a given market.
Understanding these terms is essential for successful trading in futures markets, as they provide essential information about the contracts and help traders make informed decisions. Additionally, it’s essential to understand how each of these terms relates to one another and affects the overall price movements of a given asset. By understanding the terminology used in futures trading, you’ll be well-equipped to enter trades more confidently and capture more potential returns.
The Process of Trading Futures
Once you have become familiar with the terminology of futures trading, you will need to understand how it works. When trading futures, choosing a contract that suits your needs or goals is the first step. You can trade commodities, indices, currencies, and even stocks using futures contracts.
Once you have chosen your preferred asset class, there are some key points to consider before entering into a trade:
- Do your research: Research each potential investment thoroughly as part of your due diligence process. This includes understanding the underlying fundamentals driving price movements and other factors influencing market sentiment.
- Understand the margin requirements: Futures contracts require both parties to pay an initial margin amount to open a position in the market. You should understand the margin requirements before entering into a trade.
- Set a maximum risk: Limiting yourself on your downside risk before entering a trade is essential. This will help you manage potential losses and keep them within acceptable levels.
- Utilise stop-loss orders: Stop-loss orders can limit your downside risk if prices move against you. These orders are placed at predetermined price points and will automatically close out your position if market movements trigger them.
Once these steps have been taken, the next step is to enter into the actual futures contract itself. At this point, the only thing left to do is monitor the markets closely and closely monitor your positions. It is also important to closely track the margin requirements to ensure you are adequately covered and not exposed to excessive risk.
By understanding the basic terminology of futures trading, researching each potential investment thoroughly, setting appropriate stop-loss orders and monitoring the markets closely, you’ll be well on your way to successful futures trading. With practice and patience, you can develop a sound strategy that works for you and helps capture more market gains while managing potential losses.
Note: Future trading carries a certain degree of risk, so ensure you understand the risks before entering any contracts. Establishing an appropriate level of risk tolerance and developing a sound strategy for managing your trades is also essential. Never enter into a contract based on emotion alone; always use logic and research to guide your decisions. Lastly, always remember the golden rule of investing- continuously diversify your portfolio! Best of luck with all your future trading endeavours.