Many beginner traders (and even some experienced ones) usually think that buying and selling stocks is the only way you can gain exposure to the stock market and profit. That’s fortunately not true – there are other ways you can leverage your capital and generate a return without having to actually own stock in a company with the risk that entails.
Futures trading is one of those methods. Futures have been around for centuries and offer a way to hedge against future downturns in the market while leveraging your capital today for larger returns than you’d be able to receive otherwise.
That doesn’t mean futures aren’t without risk. Here, I’ll discuss the risk of futures trading and what that means for beginner investors to pros alike.
What Are Futures – and Why Trade Them?
First, we’ll begin with an overview of futures.
A futures contract is a contract between two people that involves buying or selling a specific asset for a given price today (called the strike price), and paying for it at a later date (called the delivery date).
They originated in agriculture as a way of hedging against falling prices and other uncertainties, but now they can be bought and sold for virtually any asset out there (as long as there are people willing to buy and sell them). You can have commodity futures, stock futures, market index futures, currency futures, and other types.
Here’s an example. Let’s say you want to gain exposure to Microsoft stock, for example. Let’s also say that today, Microsoft stock is selling for $30 a share. You can buy a futures contract for 100 shares of MSFT at $30 a share today, with a delivery date of a month from now. Your hope is that the price of MSFT will be higher then than it is today.
Let’s say a month from now, MSFT is valued at $35 per share. You fulfill the terms of the contract by paying for 100 shares of MSFT not at $35 per share, but at $30 per share – the price you agreed to when you created the contract. So, in essence, you have made a profit of $5 per share, which would mean $500 in profits to you.
Of course, the opposite is true; if MSFT declines by $5, you would lose $500.
Trading futures is favorable to some because you can make a good amount of money without having to actually risk all of your money by buying stock first and then seeing what happens. Instead, you only have to pay for the stock later.
Risks in Futures Trading
There are risks, naturally.
Much of the risk in futures trading stems from the fact that you must fulfill the terms of the contract when the contract’s delivery date is reached. This is contrast to buying stocks outright or buying options. An option is just what it sounds like – optional. And with stocks, you don’t have to sell when MSFT dips to $25 per share; you can just hold onto the stock and wait for it to rise back up to $30 or higher.
But with futures, you must take action. So, the risk is that your asset will not do what you think it will do in the future. Any time you’re trying to predict the future – even with educated guesses – you are bringing even more uncertainty into the equation.
Trading on Margin
Futures trading also involves trading on margin.
When you create a contract, you must put a certain amount of money into the account, called margin. This is usually 5-15% of the value of the contract. There are two types of margin: initial margin and maintenance margin.
The first type is what you have to put in to create the contract. Maintenance margin is the amount you have to keep in your account at all times.
Margin gives you advantages; it’s what allows you to leverage your initial capital to buy far more than it would normally be able to buy. Having 10% margin, for example, means you can trade $50,000 worth of assets with only $5,000.
The big risk with this, though, is that since you control more and can earn more, you can also lose more – far more than the amount you have in your account.
If you’re controlling $50,000 with $5,000, and you lose the equivalent of $15,000 on your investment, that loss is three times the amount you originally had.
It’s a double-edged sword, and one everyone has to consider when dealing in the world of futures trading. With that being said, futures can offer a way to hedge against expected downturns, or other events, and the leverage qualities of margin-based trading that give futures trading its risk also give it much of its appeal.
Evaluate your risk profile and determine if you are willing to accept the risk for the use of leverage and big returns in trading futures.