What Are Futures? An Overview of Futures Trading
By Don Dawson | August 22, 2019
Futures trading can be done on electronic trading platforms from offices and homes all around the world and, for individual traders, does not involve storing, transporting or financing the physical commodities. These contracts are an agreement for a buyer to buy and a seller to sell a particular commodity at a pre-determined price on a specified date in the future. The goal is, of course, to be right about the direction of price movement for the commodity being traded and, therefore, capitalize on price movement.
Futures Defined and Explained
Futures are traded using standardized financial and physical commodity contracts which are created by the Exchange where the contracts are traded: New York Mercantile Exchange, Kansas City Board of Trade, Chicago Mercantile Exchange, Chicago Board Options Exchange and Minneapolis Grain Exchange. These contracts are derivatives of their respective cash markets and alleviate the investor of having to store, transport or take delivery of the physical commodity they are trading.
Futures trading is one way to diversify an investment/trading portfolio. It allows diversification among markets such as gold, interest rate products, foreign currencies and many other markets that usually move in the opposite direction of Stocks. This allows traders and investors the opportunity to prosper whether the stock market is going up or down. Think of this as hedging (insurance for a stock portfolio) in turbulent times when the market is trending downward.
Much like trading stocks or Forex, the Futures markets allows speculators to prosper if their analysis of the market direction is correct, but there are a few differences.
Difference Between Trading Stocks and Futures
While trading Stocks and having partial ownership in companies is the most common type of investment people make in the stock market, the fact that trading Futures involves trading contracts on tangible products that are used every day such as energy (e.g. oil and natural gas), food (e.g. corn, wheat, soybeans), building materials, (e.g. copper, palladium), etc. may allow traders to more closely relate to the product being traded. And, unlike Stock prices, Futures prices will not likely go to zero (e.g. it’s highly unlikely the price of gold is going to drop to zero).
In addition, Futures trading allows a trader to day trade (enter into trades and exit out of trades in the same trading session) and to swing trade (hold positions for multiple days). This is because most Futures markets are open 23 hours per day allowing trading around the clock (excluding Friday night and all day Saturday).
Another benefit of trading Futures is the relatively low start-up cost. For as little as $2,500 in most circumstances, a Futures account can be opened and traded. This is minimal compared to the Stock market where the initial start-up cost to day trade is typically $25,000 minimum.
While commissions are charged when trading Futures, the commissions are typically much lower than Stock commissions and cover the entire trade. This means that, unlike the Stock market that charges you once to purchase and then again when you sell shares, in futures trading, both the purchase and sale commissions are included in one price.
Let’s talk tax breaks. Calculating taxes due for futures trading is much simpler than for equities and is probably one of the best tax breaks left in America. For example, Futures traders do not have to itemize each transaction and the tax rate is lower than for stocks. Sixty percent of profits from futures trading are taxed at the long term capital gains rate and forty percent are taxed at the trader’s ordinary income tax rate regardless of the duration of the trade. In equities, the trade must be held for twelve months before receiving the benefit of being taxed at the long term capital gains rate.
Futures are well regulated by two agencies that help to level the playing field: Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). Both agencies oversee the Futures industry and ensure the integrity of all involved.
A Guide to How to Trade Futures
Futures trading can be done with technical analysis or fundamental analysis. In some cases, traders combine the two to get the whole picture of the market.
Technical analysis involves reading price action as it is recorded on charts. Technicians train their eyes to find repeating patterns and then write rules to follow each time they search for a trade.
Fundamentalist traders research various events and their underlying effects on the market they’re going to trade. This may involve having a good understanding of the supply/demand equation, weather conditions, issues involving governments that could impact the price of the market, and the list goes on.
Those who elect to combine the two disciplines use fundamental analysis because it drives the price of the market, and technical analysis to help time entries and manage risk. Using both of these styles together could provide a well-rounded approach to trading.
When starting out in Futures trading it is a good idea to have the right expectations. Just like mastering any other skill, trading will require education and practice. A person who aspires to be a trader, whether futures or any other asset class, should be prepared to commit the time to learn and hone their skills. In addition, they should consider how much time they reasonably have to devote to trading as this will dictate their trading style (day trader or position trader). Further, beginners should not rush into live trading. Many brokerage firms will have charting software that allows simulated trading to test a trading plan before going live with real money.
Futures has become a very popular asset class to trade. With the standardized contracts written by the Exchanges and the regulatory agencies to uphold the rules, traders have a very transparent and fair playing field. If you are interested in learning more about the stock market, sign up for a free half day class to begin your journey.
About the Author
Don Dawson has been trading the futures markets since 1987. His perseverance through the ups and downs of trading, openness to the experience of others, balanced tolerance for risk and patience to wait for his setups are a few of his strengths as a trader. His teaching method has been referred to as "down to earth". He understands the student's need for a structured environment in the early stages of their trading education. As an Instructor, he uses humor to convey information in an accessible way.
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