Is futures trading for everyone? No. Risky and complex, futures trade in a market where a misstep can cost thousands of dollars in the blink of an eye. Traders who are not well-capitalized, well-trained, and knowledgeable will almost certainly lose money in futures.
Investors should know something about the futures market, though. It sets prices for essential commodities and also affects the prices of stocks or bonds. It is an essential part of the economy.
Once a potential investor understands how the futures market works, he or she can decide whether direct participation is a good idea. Most investors decide to stay away. Others dabble in the market, using indirect investments with steadier returns.
How futures work
Every commodity in the world varies in price according to quality, quantity, location, scarcity, and time. In the futures market, prices are first divided according to time into a spot price and a series of futures prices.
The spot price is the cost of something today, right now, on the spot. Spot prices are quoted in the financial press and available online. They're the prices for large lots of commodities like wheat, gold, or cotton, and baskets of financial instruments like stocks or Treasury bonds.
Futures prices, on the other hand, are the amounts at which two traders agree to buy or sell something at a particular date in the future. They can vary substantially from the spot price.
Incidentally, though they deal in commodities, traders never end up with a trainload of wheat. Futures contracts are actually settled for cash. People who want a physical commodity generally buy it in the spot market.
Those who use futures markets are almost always hedging or speculating rather than buying or selling truckloads of stuff. Hedgers are attempting to lower risk to their business caused by price movements. Speculators are trying to profit by taking on risk.
A hedger, for example, might be someone who has or will have a large amount of wheat and who knows its price might change. Another hedger might be someone who will need a large quantity of wheat in the future. Trading wheat in the futures market, a hedger is setting the price of a commodity in advance. Whether their trades win or lose on a daily basis, over time hedgers are decreasing their price uncertainty.
A speculator, on the other hand, is not hedging against anything he or she owns. What this trader has is an opinion about the way prices will act, based on knowledge of the market. This participant is, you might say, betting on what prices the future will bring. However, speculation is not merely gambling, but an informed estimate of what will happen in the future, written up in a contract and backed by cash.
A speculator's contract, though, or a hedger's, is usually for more money than the trader actually puts up. It is amplified by borrowing, or in other words, leveraged. Contracts in the futures market are highly leveraged.
This adds to the potential gain of a correct opinion but also multiplies losses. It is leverage that makes the futures markets so very risky.
When traders open a contract, they deposit what is called initial margin. It is usually five to ten percent of the value of the contract they are entering into. This means, theoretically, that a trader can lose up to twenty times the amount he or she puts down, though in practice he or she will not be allowed to lose that much. If he or she loses enough of the initial stake, the trader will reach minimum margin and have to put up more capital. A trader can also gain though, and either way the effect of leverage is immense.
Gains and losses are calculated daily. When a trader's losses mount up to a point at which he or she no longer meets the minimum margin, he or she receives a margin call. Then, he or she must put up more money immediately, or the investment can be sold.
Traders can easily lose more than their margin due to very small movements of the commodity or financial instrument in question. Their leverage magnifies their losses. This is the real reason that futures trading is not for everyone. No one should trade futures except with money they can afford to do without.
Small investors can participate in the futures markets in indirect ways, however. Certain kinds of involvement can diversify a portfolio and allow investors to actually reduce risk, because commodities sometimes move in a different direction than stocks or bonds. Indirect ways to participate include commodity stocks, managed futures, and commodity pools.
Commodity stocks, broadly defined, are stocks of companies that produce commodities, like FCX, Freeport McMoRan, which mines for copper and gold, or XOM, Exxon, the huge oil and natural gas company. Companies that use large amounts of a certain commodity might also be very interested in futures. Some exchange-traded funds (ETFs), like XLE, hold commodity stocks, while others, like DBA, hold actual commodities. ETFs are modern mutual funds that trade on the stock exchanges.
Managed accounts are another way to participate. In this case, an investor gives a broker the authority to participate in the futures market on his or her behalf. The investor still must meet any margin calls and still has serious risk of loss. However, trades are now made by a knowledgeable trader. Investors do pay an often substantial management fee with this kind of arrangement.
Commodity pools combine the investments of many investors into a pool. This pool is then invested in a variety of commodities. This reduces any single investor's risk and avoids margin calls.
The futures markets serve a valuable purpose for the economy, helping producers and manufacturers reduce risk and uncertainty. Most investors avoid these fast-moving markets, though. They might take an indirect role through a small position in a commodity stock if they have an opinion and then stand back and watch the action.