What is Futures Trading and How Does it Work?

There are many people who want to know what is futures trading? Futures trading is simply a contract for a predetermined amount of commodities that is established today and delivered tomorrow. This type of transaction helps those that are both buyers and sellers of a specific commodity by allowing to lock in cost and have the commodity sold before it is even harvested.

Futures Trading For Speculators

Now, in order to make market prices liquid the CFTC allowed the speculator to assist in creating tighter price spreads between bid and ask prices. What are bid and ask prices? Glad you asked. Based on the perspective the bid and ask prices means the opposite to the both the buyer and seller.

For the buyer, the bid price means that this is the market price if you are planning to sell short a commodity for the purpose to position yourself for a downward move. For the buyer, the ask price is the price in which you would buy a certain commodity. The opposite would be true for the seller.

The Role Of Futures Trading Exchanges

So the futures trading exchanges are the centralized marketplace where both the buyers and the sellers of a specific commodity is auctioned off. By having a centralized location, it provides one main auction gathering for those that are interested. Prices are based on exchanges. There are some commodities that are traded at multiple exchanges like Wheat.

To determine the price of wheat, you first must look at the exchange to see what the price is at that particular exchange. Although most prices are around the same general area, you want to ensure that if you are trading Chicago Board Of Trade Wheat, you want CBOT wheat prices and not the Minneapolis exchange price.

These exchanges are also important as this is where the prices for electronic futures trading originates. Now, since many traders trade exclusively via electronic trading, real time data can be fed to investors easily since the information is originating from a centralized location.

Standardized Futures Contracts

As mentioned in the beginning paragraph, futures trading uses standardized contracts for commodities that trade. This makes things easier when calculating what your potential profits and losses when analyzing what contract you want to invest in. For instance, keeping with our wheat example, wheat is traded in a standard size of 5,000 bushels of wheat.

Each 1 cent move is $50 dollar move. The minimum move for wheat is 1/4 of a cent or $12.50 per 5,000 bushels. As you can see, unlike stocks this makes things easier to figure out. Stocks are based on how many shares multiplied by the current stock prices so that sum is varied.

Better Leverage In Futures Trading

Leverage is a double edged sword and should be respected as such. Many "get rich" programs focus on how the large leverage can make you a large chunk of cash in a very short period of time. While this is true, leverage can also work against you. If you are on the losing end, you can lose a lot of money quickly.

What do I mean by leverage? Well, in comparison to stocks, you can buy one contract of wheat for about $700-1200 dollars. That number can change based on volatility,you'll need to ensure what your margin is from your futures broker. Let assume though that the margin to place in order to secure a contract of wheat is $700 dollars and you are buying that contract at a price of 3.10.

If that price moved from 3.10 to 3.30 you would have made .20 cents or .20 x $50 dollars which equals $1,000 dollars per contract. This can happen rather quickly depending on many different factors like supply and demand or the weather. If you exit this trade you receive your margin money of $700 dollars plus the profits of $1,000 dollars. In retrospect if you bought the minimum amount of shares to trade which is 100 shares of a $20 dollar stock, you would pay $2000 dollars to establish your position. If the stock moved from $20 dollars to $25 dollars you profit would be $5 dollars multiplied by 100 or 500 dollars.

Seems somewhat close to our futures trade right? The answer is no. In futures, you risked only $700 dollars to make $1000 dollars while in stocks you risked $2000 dollars to make $500 dollars. See the power of leverage!

So now that you that you understand what is futures trading, you can make your decision whether it is more advantageous for you to invest in futures or stocks.