Futures Trading: Why Trade Them

The answer is simple: to capitalize on market opportunities presented by global macro and local micro events. When there are significant developments in the world, you can trade futures contracts correlated with those specific areas. For example, if there are issues in the Middle East, you can trade oil futures. During periods of economic volatility, gold futures can be traded. If there’s a drought in the Midwest, you can trade corn and wheat futures. And when Brexit impacts the UK, you can trade British pound currency futures.

One advantage of trading futures is the ability to participate in these opportunities in a capital-efficient manner. Unlike buying or selling an entire contract outright, futures traders only need to put up the necessary margin money for speculation. This margin requirement is a fraction of the total contract value. It allows traders to gain exposure to the market with a smaller capital outlay.

It’s important to remember that futures markets provide high leverage, which means there is the potential for amplified returns but also increased risk. Traders must carefully consider the amount of capital they want to allocate to their trading account. Leverage can magnify both profits and losses, so it should be used wisely and within one’s risk tolerance.

To illustrate, let’s consider a scenario where a single contract costs $20,000. However, to trade that contract, you may only need to post $1,000 as margin, which is just 5% of the contract’s total value. If the market moves against your position, you can incur losses exceeding your initial $1,000, potentially putting you in an under-margined position. If the market continues to move unfavorably, the losses can surpass your entire trading account balance, depending on the severity and speed of the market decline. Therefore, it’s crucial to exercise caution and prudently manage leverage to avoid taking on more risk than you can handle.

By being mindful of leverage and effectively managing risk, traders can harness the opportunities offered by futures and commodities markets while safeguarding their capital.

Similarly, when the market moves in your favor, you have the potential to achieve significant returns due to the leverage you employ. As a speculator, it’s essential to recognize that this market environment, which involves elevated risk, is closely monitored by federal regulatory agencies like the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

The NFA, in particular, serves as the regulatory body overseeing brokers, introducing brokers, futures clearing merchants, commodity trading advisors (CTAs), swap dealers, and commodity pool operators. It operates as a self-regulatory organization (SRO). While the CFTC and NFA are separate entities, they collaborate to combat financial fraud and safeguard the market against misconduct. One of their key objectives is to ensure the full segregation of funds for speculators and hedgers. This means that your funds are held separately from the operating capital of the clearing firm. Consequently, in the event of a liquidation or bankruptcy of the clearing firm (FCM), your customer funds remain secure. It’s important to note that U.S. laws do not provide guarantees for futures and commodities trading funds, so the regulators enforce rigorous supervision.

Due to this robust regulatory framework, many institutions feel confident in entrusting their funds to clearing firms. The substantial trading volume generated by these institutional players contributes to the liquidity in the futures market, enabling speculators of all sizes to engage in trading and speculation. Institutional participants hail from various regions worldwide, and the exchanges provide nearly 24-hour access to the market, five days a week.

This combination of stringent regulation, institutional participation, and extended trading hours creates a dynamic and globally accessible futures market environment.

Profiting Off Trading Futures #

Profit from both rising and falling prices of futures contracts is one of the key advantages offered by commodity futures markets. Going short allows you to capitalize on potential price declines, enabling you to benefit from both upward and downward market movements. Let’s clarify some terminology before we proceed:

  • Going long: This refers to buying a futures contract with the expectation of profiting from its price increase.
  • Going short: This involves “selling” a futures contract to seek profit from its potential price decline. To close your position, you would need to “buy” back what you had sold.

While most people understand the concept of going long (buying low and selling high), some may find it challenging to comprehend shorting (selling high and buying low to close a position). To better understand shorting, it’s important to let go of the notion that you need to own something in order to sell it. In the futures market, you can sell a contract first and buy it back later at a lower price.

Consider the following logical scenario: If you buy something at $1 and sell it at $10, you make a $9 profit. Similarly, in futures and commodities, you can sell something at $10 and buy it back at $1, resulting in the same $9 gain. Whether you profit from buying low and selling high or from selling high and buying low, the potential gain remains the same.

To further explain shorting, let’s address the question of how you can sell something you don’t own. When speculators buy a futures contract, they are purely speculating on the market direction without any intention of buying or selling the physical commodity. On the other hand, commercial buyers purchase futures contracts to secure a buying price for the actual commodity at a later time, while commercial sellers (such as farmers) use short positions to lock in a sales price for the physical commodity on a specified delivery date.

As a speculator going short, your aim is to speculate that prices will decrease, and you do this by placing margin money. Clicking the “sell” button indicates your anticipation of a market decline. From that point, the market can move in your favor or against you. Regardless, after selling, you must eventually “buy” back the contract. If the market price increases after the sell transaction, you incur a loss. Conversely, if you buy back the contract after the market price has declined, you profit from the position.

Pattern Day Trading? #

Unlike the stock market, the futures markets do not have the Pattern Day Trading Rule, which requires a minimum account balance of $25,000 for day trading stocks. This rule does not apply to futures trading. In the futures markets, you can engage in day trading and short selling without the need for a specific account balance.

There are no restrictions on the frequency of your trades in the futures market. You have the freedom to trade as frequently as you desire, taking advantage of market opportunities. Additionally, when you engage in short selling in futures, you are not required to pay interest on the short sale as you would in some other markets.

The absence of the Pattern Day Trading Rule and the flexibility it offers in terms of day trading and short selling make the futures markets an appealing choice for traders who seek to actively participate in the market without the limitations imposed by certain stock trading regulations.

Market Liquidity #

The futures market offers high liquidity due to its global nature and the ability to trade almost around the clock. With worldwide events unfolding at all times, participants in the futures market, including speculators, hedgers, and commercial players, have the flexibility to adjust their positions at any time they choose.

As a futures trader, you have the freedom to select your preferred trading hours and the markets you want to focus on. It’s important to note that while the futures market provides nearly 24/5 access, the liquidity of different markets may vary throughout the trading day.

For instance, stock indices on the CME (Chicago Mercantile Exchange) are typically most active between 9:30 AM EDT and 4:00 PM EDT, aligning with the operating hours of the New York Stock Exchange. During these hours, you may find optimal opportunities for day trading in markets like oil and gold. However, it’s essential to understand that this is not a strict rule, as market volatility can vary depending on economic releases and global events.

Even if you are located outside of the United States and unable to participate in the entire US trading session, you can still engage in futures trading by exploring other markets. For example, the German Eurex, the Japanese Osaka Exchange, or the Australian markets offer major international indices that cater to different time zones. Regardless of your location, you can find a suitable time zone that aligns with your futures trading needs.

Portfolio Diversification #

Investors have long recognized the value of diversifying their portfolios, and commodities have historically been an important component of that strategy. Futures trading can effectively contribute to portfolio diversification because different commodities exhibit varying correlations with securities markets.

When it comes to speculation, you can form opinions not only about individual stocks but also about commodities such as gold, copper, silver, or soybeans. Whether you hold a positive or negative outlook on a particular commodity, you have the flexibility to take long or short positions in the corresponding market based on your view.

If you require professional guidance to navigate the complexities of the futures markets, you have the option to work with a Commodity Trading Advisor (CTA) who specializes in specific commodity markets. These experts can provide valuable insights and assistance tailored to your trading objectives and preferences.

Hedging #

While commercial hedgers play a significant role in the futures markets, it is the smaller speculators who contribute the majority of liquidity. It’s worth noting that certain markets, like rough rice, may be predominantly traded by commercials, but the lack of participation from smaller speculators can make them less liquid, particularly in the short term.

If you are reading this, it’s likely that you are not a hedger yourself. However, it is still important to understand the role of hedgers and their impact on the market. Due to their size and influence, hedgers have a greater ability to affect less liquid markets such as dairy, lumber, rice, and sugar. Although you may not have a direct interest or need for a hedging account, being aware of their activities can provide valuable insights into market dynamics.

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