Futures contracts are foundational to the financial trading industry, offering a standardized way to buy and sell assets at a future date. These instruments are pivotal for traders looking to manage risk or speculate on price movements. This article will break down the concept of futures, and their operational mechanics, compare them with CFDs, and answer some frequently asked questions.
What are futures?
Futures are financial contracts obligating the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. The underlying asset could be commodities, stocks, bonds, currencies, or even financial instruments like market indices. Futures contracts detail the quantity of the asset and are standardized to facilitate trading on a futures exchange.
How do futures work?
Futures work on a simple principle: a buyer agrees to purchase an asset at a set price at a future point, while the seller agrees to deliver the asset at the same price and time. Even if the market price of the asset changes, the terms of the futures contract remain the same.
Here's the process:
- Initiation of a position: A trader takes a position by either buying (going long) or selling (going short) a futures contract.
- Margin requirements: Traders must put up a fraction of the contract's value, known as the margin, which acts as a performance bond.
- Mark-to-market: Futures are marked-to-market daily, meaning profits and losses are tallied and the margin accounts are adjusted accordingly each day.
- Settlement: Upon expiration, the contract can be settled by physical delivery of the asset or cash settlement, though most contracts are closed before expiration.
CFDs vs futures
When venturing into the world of trading, investors are often presented with a range of instruments, each with its own set of rules and advantages. Among the most popular are Contracts for Difference (CFDs) and futures contracts, both of which offer unique opportunities and risks. While they share some similarities in that they are derivatives and allow traders to speculate on price movements without owning the underlying asset, there are distinct differences in how they operate.
| Feature | CFDs (Contracts for Difference) | Futures |
|---|---|---|
| Trading venue | Over-the-counter (OTC) with a broker. | Traded on regulated exchanges. |
| Standardization | Customizable contracts between trader and broker. | Standardised contracts with set terms. |
| Expiration date | No set expiration; can be held as long as the trader wishes (or as long as the broker allows). | Set expiration dates; must be settled by this date or rolled over. |
| Ownership | No possibility of taking delivery of the underlying asset. | Potential for delivery of the underlying asset, though rare. |
| Leverage | Typically offers higher leverage. | Leverage is available but may be lower compared to CFDs. |
| Market access | Lower barriers to entry, more accessible for retail traders. | Higher barriers to entry, are more suited for professional traders. |
| Risk management | The trader sets the contract size, allowing for more precise risk management. | Contract sizes are fixed, which may lead to higher capital requirements for risk. |
| Costs | Financing costs for holding positions overnight; spread costs. | Exchange fees, regulatory fees, and brokerage fees. |
FAQs
1. Are futures risky?
Yes, like all derivatives, futures can be risky. The leverage involved can lead to large profits as well as significant losses.
2. Do I need a lot of money to trade futures?
Futures are leveraged instruments, so you don't need to put up the full value of the contract. However, you do need enough capital to meet the margin requirements.
3. Can I trade futures on any asset?
You can trade futures on a wide range of assets, but not every asset will have a futures market. It depends on the exchange and what they offer.
4. How do I start trading futures?
To start trading futures, you'll need to open an account with a broker that provides access to the futures exchanges. It's important to educate yourself thoroughly before beginning to trade due to the complexity and risk involved.
