What is Futures Trading?
Futures trading involves the purchasing of contracts that guarantee investors the right to buy or to sell a particular product at a specified price at a specified time. Commodities futures such as oil, corn, cocoa, and cattle are among the most popular assets used in futures trading.
Futures Trading in Practice
Let's say You enter into a contract to purchase 500 barrels of oil at the end of a three-month period.
The three-month futures price (set by market availability) for oil is $50 per barrel. Once purchased, your contract guarantees your right to purchase oil at $50 per barrel at the end of three months’ time, even if the spot price (current price) after three months ends up being higher.
If, two months into your futures contract, the price of oil rises to $60 per barrel, then your contract is worth more.
You, like most other futures traders, are interested in making money, not in buying actual oil.
Therefore, you may choose to exit your position by purchasing an offsetting contract that obliges you to sell 500 barrels of oil the next month (coinciding with the end of your original contract’s three-month term). Since the price of the underlying commodity (oil) has increased, the futures price (set by market availability) will likely be higher as well.
The 500 barrels of oil you “sell” is worth more than the 500 barrels of oil you “bought.” Therefore, you profit.
But what if the price of oil had declined, let’s say to $40, dragging down futures prices?
In that event your selling price would have been less than your buying price and you would have taken a loss.
However, had you initially bought a selling contract at $50, then purchased an offsetting buying contract, you would have profited from a price decrease.
Futures Contracts Are Highly Leveraged
The value of a futures contract is synonymous with the total obligation entailed.
In the previous example, the original oil futures contract, which obliged the purchase of 500 barrels for $50 per barrel, could be said to have a value of $25,000.
However, when purchasing the contract, you will not be asked to fork over the contract’s total value. Futures contracts are highly leveraged, meaning a small amount of money is used to control a much larger financial position.
You can usually buy or sell a futures contract by putting down a “good faith deposit,” which is somewhere around 10 percent of the total contract value. A standard good faith deposit for the oil futures contract in the example would cost $2,500 (10 percent of $25,000).
When the price of oil goes up in the second month to $60 per barrel, the futures contract will then be worth $30,000. If you decide to exit the position by selling the offsetting contract, the $5,000 profit will be added to your brokerage account.
Conversely, if the price of oil goes down, then you may not only lose your initial $2,500 investment, but you may also be required to add more funds to your brokerage account to offset the loss.