What Are Futures and Why Trade Them?
The Schwab Guide to Futures Trading
This guide can help you understand what futures are and how you can make them part of your trading strategy.
Scroll down or choose a starting topic:
- What is a futures contract?What
- Who trades futures contracts?Who
- Why should I trade futures?Why
- How can I trade futures?How
What is a futures contract?
The textbook answer is:
A futures contract is an agreement to buy or sell assets at a set date in the future for a set price.
Now let’s see what that really means with an example.
The country of Grease produces large quantities of oil.
Ride Airlines sells flights that require large quantities of oil.
At a market cost of $45/barrel:
Grease is happy with profits from the oil it sells.
Ride is happy with profits from the flights they sell.
If the price of oil rises to $55/barrel:
Grease’s profits grow by selling oil at a higher price.
Ride’s profits drop because they are paying more for oil.
If oil production rises dramatically and the price of oil drops to $35/barrel:
Grease’s profits drop by selling oil at a lower price.
Ride’s profits grow as cost of operation falls.
They both want to lock in the $45/barrel price because if it swings in either direction, one party’s profits will decrease. So they both meet with an investor who negotiates separate contracts.
Per Grease’s contract:
If the price of oil goes below $45, the investor keeps things level by paying the difference in lost profit to Grease.
If the price of oil rises above $45, Grease still receives $45/barrel and the investor keeps the additional profits.
Per Ride’s contract:
If the price of oil goes above $45, the investor keeps things level by paying the difference in lost profit to Ride.
If the price of oil falls below $45, Ride still pays $45/barrel and the investor keeps the additional profits.
Both provider and supplier get stable pricing, and are managing their exposure to the risk of a price swing—also known as hedging.
Who trades futures contracts?
There are two types of futures traders: hedgers and speculators.
Hedgers use the futures market to manage price risk, like Grease and Ride.
Speculators use the futures markets to express their opinion on, and profit from, the direction of the market, much like an equities trader. They have no intention of taking or making delivery of the underlying asset.
Traders can speculate with futures contracts on a number of underlying assets, including:
Equities Securities
Energies
(E.g. oil, gas, electricity)
Interest Rates
(E.g. Eurodollar, 30-year bonds, Fed Funds)
Commodities
(E.g. oranges, livestock, lumber)
Metals
(E.g. gold, silver, copper)
Stock Indexes
(E.g. S&P 500, NASDAQ 100, Nikkei 225)
Why should I trade futures?
There are several distinct benefits the futures market offers that the equities market does not.
Nearly 24-Hour Trading
Take advantage of global events at any time.
Leverage
Instead of having to pay the full amount for a futures contract, futures traders are only required to post margin, typically set between 3-10% of the underlying contract value. This provides potential to generate larger returns, but also larger losses.
Diversification
You can trade futures on a variety of commodities (oil, corn, metals, beef, etc.) and financial instruments (commodities, currencies, interest rates, etc.).
Short Selling
Get short exposure on the underlying asset by selling a futures contract as many times a day as you want.
Tax Benefits
Profits on futures trading are taxed on a 60/40 basis: 60% of profits are taxed as long-term capital gains, and 40% as short-term capital gains. Meanwhile, 100% of profits on stocks held less than a year are taxed as ordinary income.
How can I use what I know about trading equities to trade futures?
Starting with what you know about trading equities can be a good way to transition into futures trading.
Decide on a category and an instrument within the category
“I’ve traded various metal companies for years, and am particularly knowledgeable about gold.”
Tip: This is similar to the Top-Down approach of selecting a stock.
Conduct fundamental and/or technical research
“I like how the RSI looks and the earnings announcement was promising.”
Tip: If you primarily use either technical or fundamental for stock research, you can stick with that strategy for futures.
Form an opinion
“The price of gold is likely to rise from $1,275/oz to $1,350/oz in six to twelve months time.”
Tip: A simple starter strategy is going long to profit from a rising market with something like the E-Mini S&P.
Evaluate available contracts by size and month
“I’m going to start small for this trade. And while six months isn’t long enough, twelve may be too long, I’m going for the nine month contract.”
Tip: The three most common contract sizes are standard, mini, and micro. Depending on the commodity, the contract month may be 30 days or well over a year away.
Set exit strategy (i.e. stop-losses and profit targets)
“I already know what I’ll do no matter which way the market moves.”
Tip: Using risk management tools like conditional orders can help you protect profits and limit losses.
Execute your trade
“Here we go!”
Tip: Trade futures, equities, and options from the same trade ticket with Schwab’s platform, StreetSmart Central™.
Post initial margin
“I’ve got it covered.”
Tip: You need a minimum amount in your account at all times.
Monitor and adjust your position
“I want to maximize my profits.”
Tip: Setting alerts can help you stay on top of your trade.
