The Futures Market And How It Works

Until about a decade ago, trading was done in loud, boisterous pits in places like the New York Stock Exchange. However, as the internet grew in speed and reach, a new generation of traders began swapping financial products from the comfort of home offices and coffee shops.

This has made financial markets accessible to anyone with an internet connection. When most hear the word ‘trading’, they think about stocks. These products have notable drawbacks, though – for one, they can only be bought or sold during a stock exchange’s business hours. Secondly, commissions can be high, forcing you to not only outperform the market but your broker’s fees as well.

For some traders, the futures market makes more sense. Contracts on these exchanges can be purchased 24 hours per day, fees are low, liquidity is deep, and trades are highly leveraged. The Chicago Mercantile Exchange, a major commodities trading house, has a market cap of $67 billion dollars. The goods traded on its floor are worth many billions more. Suffice to say, it is easy to make a lot of money in futures markets.   

In this article, we’ll teach you the basics of trading futures, what you’ll need to get started, and its advantages and disadvantages versus other markets.

What is the futures market?

Before we dive deep into its inner workings, it might be helpful to know what futures markets are. Futures markets are auction-style marketplaces where commodities like crude oil, wheat, and coffee are bought and sold.

To open a position, the buyer bids on a contract. The seller responds with a counteroffer, with dialogue continuing until a price is agreed upon. This is the amount that will be paid to a supplier on a specific date in the future. This is done to provide cost certainty for the buyer and seller. In the absence of futures contracts, sudden swings in price could leave either party short of capital.

Futures markets have even evolved beyond commodities. There are platforms where you can buy non-physical products like securities, debt, and mortgages in the same way you would buy soybeans or orange juice.

Ready to buy your first contract? We’ll teach you how to do that next.

How do I trade futures?

There are two things a person needs to begin trading futures: an internet connection and access to sufficient funds. There are no certifications and educational requirements needed to begin trading; however, it is important to know your industry well to minimize your risk of ruin.

Online brokerages do have minimum bankroll requirements which must be satisfied before futures contracts can be purchased. E-mini futures, which are traded on the S&P 500, have limits as low as $500 (plus allowances for price fluctuations).

Does this mean you should sign up for a day trading account as soon as you have $500 to spare? No – the most successful traders in the business adhere to the 1% rule, which prohibits risking more than 1% of your bankroll on a single contract.

On top of this, they also employ stop/loss orders to further protect their working capital. Six ticks (the smallest rate at which a commodity price can move) is a common stop loss. If you are trading gold (which moves in increments of 0.10, each worth $10), this will get you out at -$60. According to the bankroll rule, this means you should have at least $6,000 in your account before making a trade like this.

The process for buying futures is as we described it earlier in this article: the buyer and seller negotiate on price until they reach a number that suits both parties. However,  be sure to always read every contract before buying.

When the price of wheat goes down by ten cents, it is multiplied by every bushel you bought. If you acquired 5000 bushels, this equates to a loss of $500, not $0.10. On a bad day without a stop/loss, a mistake like this could clean out your account.

Beginner futures traders should start out by buying mini futures. These instruments trade for a fifth of the value of a standard futures contract, greatly diminishing risk.

Finally, you’ll need software to not only execute trades but to also monitor positions and conduct analysis on potential deals. NinjaTrader is used by many day traders, as it offers easy-to-understand charts, feeds from market data providers, as well as the ability to set up automated trading systems.

Futures versus options

Options are popular with many beginner traders, as it is impossible to lose more than your initial investment. However, futures are less volatile than options – this means less slippage in price when executing large orders.

Futures versus CFDs

A CFD, or contract for difference, is a form of derivative that allows traders to profit off price movements without owning the underlying asset. CFDs have a lower barrier to entry than futures, as they are sold by brokers. Further, you aren’t obligated to make a sizable minimum order that requires substantial capital to finance.

On the other hand, the price of futures contracts are transparent, as they are traded on a public exchange. Relative to commissions, futures are the better choice, as experienced investors can make huge orders that dilute the impact of commissions on their bottom line.

The pros and cons of trading futures

Like any financial products, futures contracts have upsides and drawbacks. Let’s review several of them below:

PRO: Futures positions on most exchanges close overnight. This avoids losses during after-hours trading, which makes it easier for you to sleep at night.

PRO: Futures traders make more deals (2-3 per day) than other traders. Some only make one trade per week, meaning you’ll gain experience in trading quicker than investors in other fields.

CON: Commissions can be higher than you would expect. While they may be lower than other markets, they can add up over time. For example, the National Futures Association fee is $0.04 per round turn; until you attain the skill needed to be a seasoned trader, these can chip away at your slim profits.

CON: The vast majority of futures traders lose money. Beating the exchange, as well as experienced investors, is obnoxiously hard. Those who lack discipline and a willingness to do the necessary research will eventually lose their money to the market.

Like any worthwhile endeavour, futures trading isn’t easy. Most traders will go broke, heading back to their day jobs with their tail between their legs. However, if you are prepared to study a specific commodity and its related industries until you know them like the back of your hand, you’ll have a better chance of success than those who treat the market like a casino.