Futures Overview

Futures trading has become an increasingly popular instrument for investors in recent years, particularly off the back of a wider media profile for derivatives trading in general. As fund managers increasingly turn their attention to high-risk, high-reward, leveraged instruments, futures are steadily becoming a staple of the investment fund ledger, and have been a vital part of the investment mix for as long as there has been organized investment activity.

As a newbie, getting into the depths of futures trading can seem like a particularly daunting and unforgiving task (particularly in light of the troubles caused by leveraged losses), and for the unwitting trader there isn’t much margin for error. In a class of its own, futures trading demands an entirely separate understanding of risks vs. rewards as compared to other instruments before determining whether or not it’s a suitable instrument for you to trade.

Here’s a working example:

A trader buys a futures contract for wheat, which costs $10 a bushel on 1st January. The futures contract, costing $1, specifies that the trader will buy 10 bushels on 1st March at $10, and by purchasing the futures contract the trader will execute the transaction on that date, or offload the contract to another trader prior to that point.

If by the 1st March the trader executes the trade and wheat is priced at $20 a bushel, he will acquire 10 bushels for $100, realizing a $100 profit on the trade as a result. If wheat prices fall to $9, the futures contract will realize a loss.

In the secondary market for futures contracts, a price rise beyond $10 will increase the value of the futures contract, because the future will sit (at least temporarily) in a profitable position. By closing positions early, the trader can benefit from the rise in wheat prices before time, and can offload the risk of a price reversal to another trader or fund.