The Futures Trading Basics: A How-to Guide for Beginners
Are you thinking about futures trading but don’t know where to start? This futures trading basics How-To Guide is for beginners and will cover the essentials you need to know before you get going with trading futures.
Futures trading is definitely not for the faint-hearted as it is one of the more risky investment strategies. This is because when you trade futures contracts, you are essentially betting on the possible future direction of an asset.
If the asset moves in the opposite direction to your bet, you will incur a loss. Nevertheless, futures trading offers much higher leverage than share trading and can be a very lucrative way to make money if you know what you are doing.
This guide will teach you the basics of futures trading, including how to place trades, and how to manage your risk. We will also explore the benefits of futures algorithmic trading and how this system works.
By the end of this guide, you will have a good understanding of the futures market and be ready to seriously consider trading activities.
Futures trading is definitely not for the faint-hearted as it is one of the more risky investment strategies. This is because when you trade futures contracts, you are essentially betting on the possible future direction of an asset.
If the asset moves in the opposite direction to your bet, you will incur a loss. Nevertheless, futures trading offers much higher leverage than share trading and can be a very lucrative way to make money if you know what you are doing.
This guide will teach you the basics of futures trading, including how to place trades, and how to manage your risk. We will also explore the benefits of futures algorithmic trading and how this system works.
By the end of this guide, you will have a good understanding of the futures market and be ready to seriously consider trading activities.
Futures Trading Basics
The main difference between trading futures compared to stocks (which most people have a much better understanding of) is that you are not trading shares in any given company or asset. Instead, you are trading a contract to buy or sell an asset at a certain price, on a particular date in the future.
Futures contracts are used for a wide range of assets from commodities - like gold and oil, to ETFs, currencies, or even cryptocurrencies. Traditionally futures were used by companies looking to lock in a fixed price for a certain time period. This allowed the buyer and the seller to work with a guaranteed price, regardless of actual price variations.
These companies, known as hedgers, set up futures contracts on deliverable assets that they need for their company to operate. Imagine an airline that has a contract for aviation fuel from its provider. Both the buyer and the seller agree to a fixed price for a given period to reduce their risk of exposure to price fluctuations.
In contrast, speculators and investors are individuals that have no intention of ever providing or taking ownership of the underlying asset. They are rather looking to trade contracts in the futures market.
This is where you can make money as a beginner futures investor as every day a large volume of contracts are traded. By buying and selling futures contracts as the asset value fluctuates you can take advantage of these price movements.
Futures contracts are used for a wide range of assets from commodities - like gold and oil, to ETFs, currencies, or even cryptocurrencies. Traditionally futures were used by companies looking to lock in a fixed price for a certain time period. This allowed the buyer and the seller to work with a guaranteed price, regardless of actual price variations.
These companies, known as hedgers, set up futures contracts on deliverable assets that they need for their company to operate. Imagine an airline that has a contract for aviation fuel from its provider. Both the buyer and the seller agree to a fixed price for a given period to reduce their risk of exposure to price fluctuations.
In contrast, speculators and investors are individuals that have no intention of ever providing or taking ownership of the underlying asset. They are rather looking to trade contracts in the futures market.
This is where you can make money as a beginner futures investor as every day a large volume of contracts are traded. By buying and selling futures contracts as the asset value fluctuates you can take advantage of these price movements.
How Do Futures Contracts Work?
Each futures contract is standardized with a number of parameters that cannot change. Keeping these details the same means that it is easy for investors to exchange futures based on the current price of the asset, not the volume of the contract.
For each underlying asset, there is a fixed standard of measurement used to calculate the value of the contract. This unit of measurement varies according to the commodity or asset. For gold, the standard futures contract is for 100 fine troy ounces, whereas oil is set at 1000 barrels.
Each contract will also specify the currency unit involved, as well as the grade of the product, should this be applicable.
Most importantly, the contract will state how the two parties will settle the trade at the end of the time period. This could either be a physical delivery of the actual commodity or a cash settlement.
For each underlying asset, there is a fixed standard of measurement used to calculate the value of the contract. This unit of measurement varies according to the commodity or asset. For gold, the standard futures contract is for 100 fine troy ounces, whereas oil is set at 1000 barrels.
Each contract will also specify the currency unit involved, as well as the grade of the product, should this be applicable.
Most importantly, the contract will state how the two parties will settle the trade at the end of the time period. This could either be a physical delivery of the actual commodity or a cash settlement.
Leverage and Margin on Futures Contracts
One of the reasons why futures are popular with highly experienced traders is the high leverage that you can use when trading futures. This can mean a much bigger return on your investment, but can also carry a significant risk.
Most stockbrokers will offer around 2:1 leverage for a standard share trade on the stock market. When you compare this to the 20:1 leverage that you can get with futures trading it is easy to understand why futures are so attractive.
To understand leverage in futures trading consider how a real lever can increase your lifting capacity. This is exactly the same principle that an investor can use to significantly multiply their buying power with a minimal up-front investment.
As a futures investor, you only need to put in a small margin of the total value of the contract. This figure is usually around 10 percent of the contract.
By doing this you can buy a far more valuable contract than your investment. However, should the market move more than 10 percent in the opposite direction to your position you will need to add more money.
High leverage gives investors the opportunity to make large profits with the minimum investment. The risk is that even a small percentage change in the wrong direction can result in an equally large loss.
To manage this risk it is vital to set up a stop-loss order on every trade you make. This allows you to automatically sell or buy your trade once it has reached a predetermined price. Although you will still make a loss on the trade it will limit the amount to what you have preselected.
How to Start Trading Futures
To make your first trade you will need to open an account with a broker that offers futures trading as part of their package. You should expect them to ask some detailed questions about your prior trading experience, average monthly income, and net worth.
Based on your answers the broker will make a decision about how much leverage they are willing to offer you. Once you have an account you can decide which market and asset you would like to trade in.
Your broker will then decide on the required margin that you will need to provide before opening the trade. This is the up-front capital you put in to buy a contract. For example, if the contract is worth $150,000 and the margin is set at 10 percent then you’ll need to pay $15,000.
Each day your broker will determine what the current value of your contract is. They will then add or subtract this amount from your account. Using the same example if the contract value increased to $151,000 then you would see $1,000 added to your account.
Most brokers have a system in place to ensure that you close your position before the contract expires. This means you will never have to provide or take delivery of the underlying asset.
There are no fixed commission fees for trading futures and these will vary according to the broker. Most brokers charge a monthly fee to use their platform and access market data.
Make sure you investigate which is the best futures broker for your requirements before signing up with a platform.
Based on your answers the broker will make a decision about how much leverage they are willing to offer you. Once you have an account you can decide which market and asset you would like to trade in.
Your broker will then decide on the required margin that you will need to provide before opening the trade. This is the up-front capital you put in to buy a contract. For example, if the contract is worth $150,000 and the margin is set at 10 percent then you’ll need to pay $15,000.
Each day your broker will determine what the current value of your contract is. They will then add or subtract this amount from your account. Using the same example if the contract value increased to $151,000 then you would see $1,000 added to your account.
Most brokers have a system in place to ensure that you close your position before the contract expires. This means you will never have to provide or take delivery of the underlying asset.
There are no fixed commission fees for trading futures and these will vary according to the broker. Most brokers charge a monthly fee to use their platform and access market data.
Make sure you investigate which is the best futures broker for your requirements before signing up with a platform.
Advantages to Trading Futures
The main benefit of trading futures is the amount of leverage that brokers offer on these investments. With such high leverage, it is possible to make a considerably bigger return on your investment than what is possible with standard stock trading.
Imagine that you want to invest $1,000 in a business with a stock price of $100 dollars. With a normal stockbroker this would mean you could buy 10 stocks, whereas with a futures broker you could buy a contract for 100 stocks with a 10 percent margin.
Now imagine that the stock price goes up by $10. This would give the investor in the normal stock a $100 profit. Not a bad day, but way less than the $1,000 that the futures investor would make! By trading with 10 times more exposure it is easily feasible to make a much bigger profit than regular trading.
Another major advantage to futures is that the market is highly liquid. This means a huge number of future contracts are being bought and sold each day and so your orders can be placed quickly. Future markets also trade beyond normal trading hours and some are open for trading 24/7.
The commission fees paid on future trades are generally very low and are only paid after the position is closed. These can be as little as 0.5 percent of the contract value, although this depends on the level of service that the broker has provided.
Here are some examples of the leverage you can get with futures. Note how the amount of leverage varies with instrument. As described in next section, "watch out!" with leverage...
Imagine that you want to invest $1,000 in a business with a stock price of $100 dollars. With a normal stockbroker this would mean you could buy 10 stocks, whereas with a futures broker you could buy a contract for 100 stocks with a 10 percent margin.
Now imagine that the stock price goes up by $10. This would give the investor in the normal stock a $100 profit. Not a bad day, but way less than the $1,000 that the futures investor would make! By trading with 10 times more exposure it is easily feasible to make a much bigger profit than regular trading.
Another major advantage to futures is that the market is highly liquid. This means a huge number of future contracts are being bought and sold each day and so your orders can be placed quickly. Future markets also trade beyond normal trading hours and some are open for trading 24/7.
The commission fees paid on future trades are generally very low and are only paid after the position is closed. These can be as little as 0.5 percent of the contract value, although this depends on the level of service that the broker has provided.
Here are some examples of the leverage you can get with futures. Note how the amount of leverage varies with instrument. As described in next section, "watch out!" with leverage...
Disadvantages to Trading Futures
Just as high leverage is the biggest benefit to trading futures it is also the biggest disadvantage. This double-edged sword means that only a small percentage drop in the value of your contract can quickly wipe out your margin.
Futures can be complicated for new traders to understand as each asset has its own set of price movement amounts. This means each tick up or down is a different amount for each asset and traders need to know what these amounts are to accurately access their risk.
New futures investors also need to be aware of which commodities have daily price limits. For some commodities, there is a limit on how much the price can change each day.
Once they reach this limit, traders are unable to continue trading. This can force you to hold onto a contract that is incurring a loss.
Even though you only need to provide a 10% margin the entry amounts for futures contracts are still substantial compared with normal stock options. For blue-chip companies, the margin deposit on a contract can easily be $25,000. These high entry prices can be too large for a beginner investor to make.
Futures can be complicated for new traders to understand as each asset has its own set of price movement amounts. This means each tick up or down is a different amount for each asset and traders need to know what these amounts are to accurately access their risk.
New futures investors also need to be aware of which commodities have daily price limits. For some commodities, there is a limit on how much the price can change each day.
Once they reach this limit, traders are unable to continue trading. This can force you to hold onto a contract that is incurring a loss.
Even though you only need to provide a 10% margin the entry amounts for futures contracts are still substantial compared with normal stock options. For blue-chip companies, the margin deposit on a contract can easily be $25,000. These high entry prices can be too large for a beginner investor to make.
What Is Futures Algorithmic Trading?
When it comes to trading futures, some investors prefer the hands-off approach of using algorithmic trading strategies. This is commonly referred to as algo-trading. The biggest difference in this type of trading is that the investor no longer needs to monitor price graphs.
Futures algorithmic trading is a type of trading that uses computer programs to automatically make trading decisions. These software programs can constantly monitor the price and moving average of any number of assets. They can then buy or sell when predetermined conditions are met.
If you’re interested in futures algorithmic trading, there are a few things you should know. First, it’s important to understand the basics of the algorithms and how they work. Second, you need to have a good understanding of the markets you’re trading in. And third, you need to be comfortable with risk.
If you’re willing to put in the time to learn algo-trading and you’re comfortable with risk, then futures algo-trading could be right for you.
Futures algorithmic trading is a type of trading that uses computer programs to automatically make trading decisions. These software programs can constantly monitor the price and moving average of any number of assets. They can then buy or sell when predetermined conditions are met.
If you’re interested in futures algorithmic trading, there are a few things you should know. First, it’s important to understand the basics of the algorithms and how they work. Second, you need to have a good understanding of the markets you’re trading in. And third, you need to be comfortable with risk.
If you’re willing to put in the time to learn algo-trading and you’re comfortable with risk, then futures algo-trading could be right for you.
The Benefits of Futures Algorithmic Trading
Futures algorithmic trading can provide a number of benefits. These include the ability to take advantage of market inefficiencies and to trade in a highly automated and efficient manner. Algo-trading also allows you to manage risk more effectively.
While futures algo-trading is not right for everyone, it can be a useful tool for those who are able to use it wisely. It can help you identify opportunities in the market that you may not have been able to capitalize on otherwise. Algorithmic trading can also help you execute trades quickly and at the best possible prices.
If you’re thinking about pursuing futures algorithmic trading, it’s important to do your research and make sure that it’s right for you. There are a number of risks involved with algo-trading, and it’s not suitable for everyone. However, if you’re willing to take on the risks, using an algo-trading strategy can be the ultimate tool in your futures trading arsenal.
While futures algo-trading is not right for everyone, it can be a useful tool for those who are able to use it wisely. It can help you identify opportunities in the market that you may not have been able to capitalize on otherwise. Algorithmic trading can also help you execute trades quickly and at the best possible prices.
If you’re thinking about pursuing futures algorithmic trading, it’s important to do your research and make sure that it’s right for you. There are a number of risks involved with algo-trading, and it’s not suitable for everyone. However, if you’re willing to take on the risks, using an algo-trading strategy can be the ultimate tool in your futures trading arsenal.
Do You Want to Start Trading Futures?
Now that you have an understanding of futures trading basics, do you feel confident to start trading? Probably not yet, right? That’s why you need to have a trading strategy that you are confident in using.
With 30 years of trading experience, KJ Trading Systems offers a complete Strategy Factory Workshop on futures trading algorithmic strategy development. This workshop will give you the skills and confidence to start algo-trading futures.
Have a look at the Strategy Factory Curriculum to see how we cover all the essential components of building and testing a powerful strategy to suit your needs. By doing the workshop you will have the opportunity to create your first strategy under the guidance of an expert trader.
Alternatively, you can sign-up to receive a free copy of Champion Trader Kevin Davey’s algo-trading strategy and find out of algo trading is right for you.
With 30 years of trading experience, KJ Trading Systems offers a complete Strategy Factory Workshop on futures trading algorithmic strategy development. This workshop will give you the skills and confidence to start algo-trading futures.
Have a look at the Strategy Factory Curriculum to see how we cover all the essential components of building and testing a powerful strategy to suit your needs. By doing the workshop you will have the opportunity to create your first strategy under the guidance of an expert trader.
Alternatively, you can sign-up to receive a free copy of Champion Trader Kevin Davey’s algo-trading strategy and find out of algo trading is right for you.
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About The Author: Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 25 years.Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.
Kevin is the author of 5 highly acclaimed books, including "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: https://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.
Kevin is the author of 5 highly acclaimed books, including "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: https://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.