Trading in futures is a type of investment which entails speculating on the price of a commodity increasing or decreasing in the future. In this kind of trading, it is rare that the traders have the real commodity because it mainly deals with intangible commodities. Futures traders deal with just a piece of paper that is known as a futures contract.
Futures trading is therefore the trading of futures contracts which lets particular stocks indexes, assets or commodities to be traded at a preset price in future. When trading in futures, the first step is to buy a contract which will have a specified lot size of index shares depending on the stock index. The lot size of futures varies with the type of contract.
Having bought the futures contract you are not expected to pay the entire value of the contract but rather just the margin. The margin too is determined by what the futures exchange sets for that particular day. It is worth noting that both parties in a futures contract must meet the terms of the contract on the delivery date. The seller delivers the underlying assets to the buyer or if it was a cash contract the money is transferred from the trader who made a loss to the trader who made a profit.
There are two major types of futures traders: hedgers and speculators. A hedger is the producer of the commodity being traded and trades a futures contract to safeguard himself from future price fluctuations. Speculators on the other hand include private investors and floor traders. Speculators invest in futures by buying commodities at a low price and selling them at a high price.
There are several benefits of trading in futures over trading in stocks.
One of the main benefits is that futures traders have a chance to do pre-market trading thereby getting a big head start on gaining profit that day. Stock traders do not enjoy that privilege because they can not trade until the market opens. Secondly, trading in futures has a significant contribution on risk management in an investor’s portfolio with potential tax benefits. The capacity to hedge a particular stock index allows you to hold onto the underlying position in the stock market for a longer time thus, potentially providing you with considerable tax savings in the longer term. Commission savings is also an advantage in the sense that the transaction cost in trading in futures amounts to much less than buying or selling the same number of shares of stock in the stock market.
For stocks, margins are determined by the Federal Reserve Regulation which means an investor buying on margin borrows the difference. He can either pay down the loan or compensate when the security is sold. In futures trading, margins are set by the exchange, but they do not represent a down payment on an asset and are quite low.
You also benefit from spread differentials, that is, if you feel that the commodity price will decline or rise in relation to another correlated commodity, you can buy a futures contract on one commodity and sell it on another hoping to profit from the spread differential between the two commodities.
Trading in futures also allows you to trade across borders without going through foreign clearing systems. This means that futures transactions will be clear of costs of accessing settlement systems across international borders.