Futures are a type of derivative on the markets. What makes them a derivative? The value of the contract is “derived” from the underlying asset.
They are not actually “stocks”. Unlike stocks, you’re not buying a share of a company, per se. Instead, you’re buying a contract. And that contract is an agreement between buyers and sellers to make the transaction at the end of the contract expiration date.
Unlike stocks, futures may require you, the buyer, to take possession of the underlying commodity when the contract expires. For example, if you buy December gold futures, your contract will expire at the end of December and you will need to take possession of the commodity or its cash equivalent, which will depend on the exchange where the contract was purchased.
That said, futures are often bought and sold much like stocks. They are an opportunity for speculators to bet on prices falling or falling in a certain commodity or index. In addition, they are often used as a hedge for other portfolio positions such as stocks. In fact, there are quite a few asset classes that you can trade as futures. Here are a handful:
- Metal futures for gold, silver, nickel, copper, etc.
- Index futures for markets such as Dow, NASDAQ and S&P500
- Commodities such as wheat, corn, crude oil, soybeans
- , Bitcoin futures and treasury bonds
Currency futures
No matter what futures you buy or sell, you’ll want to make sure you have a good understanding of supply and demand dynamics, technical analysis, and even world events. We’ll discuss some of these future strategies in a moment.
HOW TO TRADE FUTURES
There are many strategies that can help you learn how to trade futures, but you must first start with a broker that offers futures trading. There are many to choose from and we won’t get into it here. Instead, we discuss the ramifications of margin, speculation, buying and selling, and hedging.
Most brokers offer traders the ability to trade using margin. In other words, your purchasing power is harnessed with only a small amount of start-up capital. This allows you to negotiate contracts without putting in place 100% of the contract value. Some brokers will give you 20:1, others 100:1, or even higher leverage to your initial deposit.
As we said before, this can be a Catch 22. Know what you’re doing, or that amount of leverage will quickly eat up your account.
Speculating on futures is one of the most popular ways to trade futures. It’s like any other speculation. Buy a contract betting that it will go up in price, and you will have a profit once you sell the contract. You can also trade futures on the short side, betting on the price of a commodity to go down. We call this short selling.
If you sell a futures contract in short and it drops in price, you will hedge your short position and make a profit once you reach a targeted and lower price.
Finally, many institutions and traders trade futures for hedging purposes. Hedging is a fancy term to protect your positions in the market. For example, let’s say you have a long position in the S&P500. As a long-term investment vehicle, the S&P500 is expected to continue upwards. However, in the short term, it is expected to make a correction and go downwards.
To protect your position for the long term, short the S&P500 futures until the end of the correction. This protects you from any real losses in your main wallet.
FUTURES TRADING STRATEGY
Just like the world of stocks, there are tons of futures strategies to choose from. Some are quantitative, others discretionary. Regardless, most future strategies will be based on repeatable patterns. In this sense, we discuss the importance of liquidity zones and use an example of a reversal strategy to illustrate how to trade futures.
Liquidity zones are areas on a futures chart that tell you where the big players are accumulating or distributing their contracts. Typically the price will gather in these areas as long as there is demand or demand. However, once the supply is exhausted, or vice versa, the price will move away from the area in the direction of less resistance.
When a futures contract is being accumulated, it will often remain in an area long enough for institutions to accumulate contracts. Once enough contracts have been purchased, the price is marked. Then, see how the price moves higher from these liquidity zones.
Conversely, when the price of a commodity has expanded too much, it is likely to see the distribution of those contracts that have been accumulated at much lower prices. The result is “ease of movement” in the liquidity zones that previously supported the asset.
Find a setup within a futures trading strategy
Now that you’ve seen the general idea of how a future business can move, you’ll want to add a template or “setup” to your arsenal. This will give you a way to define your risk before taking a position, long or short.
For example, let’s look at the long side.
We have already written about the pattern of volatility contraction and short traps. The volatility contraction pattern is usually an indication of a large demand in a commodity, stock, or other asset. It reveals that supply is hard to find and that demand constantly supports the price of the asset.
In the crude oil example above, if we compare the 30-meter charts, we see this model playing before getting a toss from the entire base.
Note that despite the failure of the collapse, crude oil continued to hold higher lows. Moreover, we can assume that the selling pressure that came on the failure of the bankruptcy only fueled the price of the goods higher. Because? If there were short sellers in that selling pressure, they eventually had to hedge their positions as the price rose.
We hope you will see that many of the same models we use in stock trading can also be used as futures trading strategies. For this reason, be sure to practice your strategies in our simulator to determine your best possible results before putting real money to work.