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What You Should Know About Investing with Futures

By: Elite Legacy Education, December 6, 2016

What You Should Know About Investing with Futures

What are futures?

Just as the name suggests, futures are all about what will happen with an asset in the future. A futures contract represents an agreement between two parties to buy and sell a particular asset at a specific price at some point in the future. This may sound similar to how options work, but there is a difference. Options grant the option buyer a right to exercise the option, whereas futures create an obligation for the deal to be honored. Specifically, when you enter into a futures contract, the agreed upon deal will be executed at a later point in time regardless of whether you want it to or not. Thus, futures require a little more confidence from each party since the trade of the underlying asset will be executed no matter what. Some futures require that the underlying asset actually be traded, while others settle the difference in prices using only cash. These are always traded on futures exchanges, which exist in many countries.

Futures can be tied to assets and rates such as:

  • Foreign Currency Exchange Rates
  • Agricultural Commodities
  • Metals and Energy Commodities
  • Interest Rates
  • Equity Indices

 

What’s your position: Long or short?

Since futures represent an agreement between two parties to trade an asset at a particular price in the future, it requires two different positions. The first position is a long position which means the investor is betting on the fact that the asset price will rise. The second position is a short position in which the trader is betting on the fact that the asset price will drop. Every futures contract has a long position and a short position, since it wouldn’t make sense for each party to bet on the same outcome.

What are futures used for?

Futures are used for very similar reasons to options. This makes sense since there is very little difference between the two other than the fact that the former is obligatory and the latter is optional. These uses include:

  • Trade Speculation: This is for the sheer purpose of betting on the direction of a particular asset. The predicted price direction is reflected through the long and short positions of each party.
  • Risk Hedging: Futures can be used to minimize potential losses on an underlying asset. You do this by betting on the opposite direction that you took when investing in the underlying asset. Specifically, if you invested in a long position for an asset, then your future would take a short position. Thus, if the asset’s price activity doesn’t play out as expected, then your futures position will help to minimize losses. However, this also works in reverse if your gains will not be realized to their full potential. This is because your futures position would be taking a loss.

 

The timing of futures.

The following terminology describes key dates in trading futures:

  • Contract Month: This is the date of expiration of the futures. Essentially, this represents the point in time where the current underlying asset prices are compared to the initial prices when the futures contract was established.
  • Delivery Date: The delivery date occurs afterwards and represents the point in time whenthe underlying commodity must be delivered to the new party.

The main difference is that the gains and losses are calculated in the contract month, whereas the transfer of assets occurs on the delivery date.

So there you have the basics of trading futures. If you would like some hands-on practice, there are some opportunities for you. Some futures exchanges, like the one in Montreal, Canada, offer simulations where traders can participate in a virtual market with fake money. This allows you some time to practice before putting your money on the line.

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