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FUTURES TRADING - Frequently Asked Questions

Please find below more information Futures Trading. Just click on the links to get more information.

        

What is Futures Trading?

Futures Trading involves speculating on the future price of a commodity. Some of the main Commodities traded are:

  • Metals such as Gold and Steel
  • Grains such as Corn and Wheat
  • Energy
  • Cotton
  • Beef
  • Currency
  • Timber

These are all traded constantly by investors all over the world, via an exchange or brokerage.

Essentially, the trader is betting (or speculating) on the future price direction of a commodity. If the trader thinks the price will be increasing in future, they buy a futures contract. If they think the price will be going down in future, they will sell the futures contract.

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What if I don't want to own the Commodity?

Most traders will never see the commodity they are trading. Because the agreed exchange is set for a future date, most traders offset the obligation before that date. So, you can even sell first and buy back later.

Therefore, you do not need to actually make or take delivery of the commodity (for example, a large amount of corn) because most traders offset their position before the due date on the contract.

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What is a Futures Contract?

Unlike regular stocks or bonds investing, futures trading means you do not actually have to own or buy anything. You are simply speculating on the commodity and which future direction its price will take.

A futures contract means the trader buys or sells a commodity for a preset price and at a pre-determined time period. He or she is then obliged to buy or sell that commodity at a future date.

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What Types of Traders are there in Futures?

The two most common types of traders in Futures are:

The Hedger:

This is the person who produces the commodity - such as the farmer. He or she wants to protect against future price changes of the product, and therefore trades a futures contract. The farmer wants to ensure that even if the price of the crops fall by the time it comes to harvest, he or she can still make a profit. Futures trading allows you to sell before you buy. This is done by selling a future contract before buying it. The farmer sells at a high price and buys it at a lower price before the expiration date, allowing him to make a profit. He can make this profit even if the cash price of his crop goes down, because he is making back the loss by profiting on the short-selling of the futures contract.

The Speculator:

This is the most common kind of Futures trader. He or she wants to make a profit by speculating on the future price (ie if it will rise or fall) of a commodity. The speculator invests in futures in a similar way to investing in the stock market.

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How Much Capital is Required to Start?

When you open a futures account, you will need to pay an initial margin. This will be a percentage of the value of the contract that is made with the broker. The amount of the margin is also set by the broker or exchange, and will vary according to fluctuations in the market and price movements. Usually margin deposits are around 2 to 10% of the value of the contract.

The profit made in this kind of trading is through margin.

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Where Does Trading Take Place?

Futures trading takes place via a central Futures Exchange. Companies are listed on an exchange, and traders can access electronic Futures trading platforms via these. One of the world's largest in the teamed-up New York Stock Exchange and Euronext, which provide inter-continental internet trading platforms. This means that investors can trade from anywhere in the world using an internet connection - even from home.

We have provided a list of World Futures Exchanges in our Information Library.

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Is Futures Trading Regulated?

Yes; each Futures Exchange is regulated by the government regulatory body of their country. In the UK, futures exchanges are regulated by the FSA (Financial Services Authority). In order to be able to trade through a futures exchange, a company must be regulated. You can check this by going to the FSA website.

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How Are Prices Shown?

Prices in the futures market are mostly quoted by currency denominations per commodity - so for example pounds and pence per bushel of wheat. If the contract you hold is in a cash settled index, the prices will be quoted in an index number. Before you begin, it is wise to familiarise yourself with the prices system of the contract you are thinking of taking out.

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What About Price Changes and Limits?

Because of the basic nature of supply and demand, prices in the futures market are constantly changing.

Each day, the futures exchange will decide on a minimum amount that prices may go up and down - or fluctuate. This is called the "tick", and traders will make sure they are aware of what the "tick size" is each day. This, and any price changes, will affect the value of the contract the trader holds.

Futures exchanges will also set a price limit each day. These are calculated by the the closing price of the previous day plus or minus the trading unit's pence or pennies (or cents and dollars).

Tip: In the month in which your contract expires, prices can change frequently and become volatile. For this reason, it might be worth considering closing or liquidating a position before the expiration month if you are a less experienced trader.

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What are the Advantages in Futures Trading?

There are many pros and cons to this type of trading. Advantages include:

Leverage

You do not need a huge amount of money to begin futures trading - the deposit being the small margin. This is less a down payment, and more a form of security for both parties. If the trader predicts the future commodity price incorrectly and consequently loses, he will lose the entire margin and very likely more on top of that. If the trader wins on his position, then he will make the profit and get the margin back on top of this.

As the trade operates on margin, you only need a small amount of the total value of the commodity in order to take a position. With a relatively small amount, you could multiply your gains - but also your losses.

Commission

You will be charged commission when entering Futures trading, but this will be a relatively charge when compared to other types of investment - and these are paid after the contract is closed.

The amount of commission varies according to broker - those who provide a large amount of value-added services and advice may charge more commission than perhaps some online services.

Liquidity

The world futures market is huge, and a vast volume of trades are taking place all the time. A large market means plenty of opportunities to buy and sell on commodities. Orders can be placed quickly, and compared to other markets, there is less likelihood of sudden and drastic changes in prices.

Easy to Trade

Futures trading allows the investor to become involved in a potentially huge market and commodity without actually having to own them, and the many online platforms available mean that trading can take place virtually anywhere - even from home.

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What are the Disadvantages?

As with most types of investment trading, Futures trading involves some setbacks, and is a high-risk activity.

Leverage

Leverage is both an advantage and a disadvantage.

Let us say you have 2,000 in your pocket which you would like to invest. You may be able to use this money as a margin to buy some futures contracts in Wheat - worth 20,000. Now, if the price of Wheat drops by 10%, you will lose 2,000 (ie the initial margin amount) plus you may lose the entire funds in your account.

Therefore, it is wise to ensure you are able to pay the initial margin and be prepared that you may make huge losses.

A loss can exceed the initial margin and the amount within an account.

Lack of Knowledge

Futures trading is a potentially lucrative investment process, but it does require a good amount of background work in order to be aware of the risks involved. It is not worth entering the market without sufficient knowledge on the type of trading and the markets.

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What is the Difference Between Futures and Options?

Options contracts are offered by most Futures Exchanges. They are very similar to Futures contracts, but the main difference is:

An options contract means that the buyer is given the right not the obligation to buy or sell an asset.

Similar to a Futures contract, the contract is agreed for expiration at a future date at an agreed price. Options are divided into two:

A 'call' option means that the buyer has the right to buy the underlying asset.

A 'put' option means that the buyer has the right to sell the underlying asset.

So assuming the buyer decides to exercise his or her right, the seller is then obliged to buy or sell the asset at the pre-agreed price.

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What are the Fees?

When you are looking for the right Futures contract, you will be looking at a number of brokerage firms and trading platforms. Among the commissions on trades already discussed in this document, you might choose to have an account manager. Having someone manage your account gives you a guiding hand through the market, but there may be additional costs involved in having an account manager. They may require management fees for example.

Before you make a choice, it is therefore wise to study all terms and conditions, and find out what all the extra costs may be. Brokerage firms are obliged to provide new traders with all necessary information, and you are well within your rights to request further details should you need them. They should also provide each new account holder with a risk awareness document.

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What are the Risks?

As with most types of trading, Futures trading carries grave risks to your capital.

You Could Lose All Capital - and More

By taking a Futures contract, you could lose all of your invested funds, your initial margin plus additional funds.

If you intend to enter the Futures market, it is recommended to only invest capital that is risk capital - in other words, capital that you can afford to lose. The risk of losing capital is extremely high in this type of trading, and most traders will lose capital at some point.

Understand Leverage

As mentioned in the Disadvantages section, leverage means that while profits can be large, so losses can be large and absolute. You may be obliged to cover losses and extra deficiencies over what you may have expected to pay for your contract.

Therefore, it is wise to be clear on leverage - both the concept and what it could mean for you in terms of loss.

Be Clear on Margins

Make sure you understand the Margin Agreement of your brokerage provider. Brokers can vary in how they require margins to be met and if you are unable to meet their requirements, they may have protection in place which could involve your contract being liquidated - which could result in a loss.

Consider Stop Orders

In order to try and limit a loss amount, many traders place a Stop Order with their futures broker. This means they buy or sell a contract when the price reaches a certain specified level.

Please note: Stop Orders can not guarantee that your order is met to the price agreed. Markets are extremely volatile, and can move so quickly so often that the specified price cannot be met. Make sure you are clear on the rules of your Exchange's Stop Orders.

More Information on Futures Trading Risks

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