Nicholas Fainlight is an aspiring finance professional.

Tag: contracts

Futures trading part 2- leverage (1)

Futures Trading Part 3: Risk

If this is your first time tuning in, then you’ll probably want to check out my first two blogs in this futures trading series first, where I cover a basic introduction to futures trading and leverage. I’ve had an interest in futures trading for about as long as I’ve had an interest in finance- which is to say, it’s been awhile. It’s a tricky area of the stock market to explain to anyone because it is both a part of and separate from the overall stock market. Long story short, futures contracts have set expiration dates and stocks do not. But there’s a lot more to it than that, so I broke my explanation of futures trading into four sections covering key concepts. This is lesson three of four, covering risk.

Risk: you know what it is in general terms, but do you know how it relates to futures contracts? Unless you study the stock market as I do, probably not, but I’ll do my best to explain. Essentially, investing in futures contracts can be risky business. Managing risk is an important consideration for stock investment; however, unlike with traditional trading, with futures trading you can stand to lose more money than you put in. Therefore, you should have a full understanding of risk capital before trading in futures.

Risk capital is defined as the funds that traders can afford to lose. According to Rich Ilczyszyn, CEO and founder of iiTRADER.com, “You should not be trading futures with money reserved for necessities, such as housing, food, transportation.” Instead, you should consult an experienced broker to help you develop and assess your risk profile, and determine the right asset classes.

To know what you’re getting yourself into and avoid trading with risk capital, there are several considerations that should factor into your decisions before trading in futures. First, do your research and go with an experienced brokerage firm. Commission rates, margin requirements, level of executions, types of trade, software and user interface, and customer service are all important considerations. Also consider the level of service you require. If you’re more of a do-it-yourself person, then you may want to save yourself some money and go with a discount broker for lower commissions and fees. However, if you’ve never traded in futures before (or any stocks) then a full-service broker may be for you, as they will provide a higher level of service and advice for a slightly higher cost.

Your next considerations should be the category and type of futures that you want to trade. There are various categories involved in the futures market, which Investopedia suggests thinking of as industries. The individual contracts within these categories can be compared to stocks. For instance, agriculture energy, equity index, currency futures (FX), interest rates, and metals are all categories and there are contracts within those categories. As a general rule of thumb, you should stick to what you know when deciding which market categories and instruments you will trade. If you have a background in agriculture, for example, then you might want to trade in that category since you already have an understanding of the market.

There are also different types of trades to consider. At the most basic level, you can either buy or sell futures contracts, but there are different trading techniques employed by futures traders, starting with basic trades whereby the trader makes a wager that the price difference between investment and futures will fluctuate, and encompassing spread trades (a wager that the price difference between two futures contracts will change) and hedging (where a trader sells a futures contract to protect against a stock market decline).

My explanation of risk management in futures trading is by no means exhaustive, but hopefully it makes you realize that there are a lot of important considerations that go into futures trading and encourages you to do your research before committing to a contract.

Futures trading part 2- leverage

Futures Trading Part 2: Leverage

I promised I would give you a four-part series on futures trading, and I always deliver on my promises. So ta-da, here it is for those of you who have an interest in the stockmarket like I do. In my first post about futures trading, I gave a general introduction to this area of the stock market, where I described what futures contracts are and how they work. As a refresher, a futures contract is a standardized forward contract between a buyer and a seller in which the delivery and payment of the asset occur at a future point in time. Because futures are functions of underlying assets, they are derivative products, meaning they derive their value from the price movements of the various assets they pertain to.

Leverage is a key concept of futures trading, and anyone looking to get into this field should have a thorough understanding of it. According to Rich Ilczyszyn, CEO and founder of iiTrader.com, “Leverage allows traders to make a large investment in a commodity using a comparatively small amount of capital.”

So, an investor that is interested in buying or selling a futures contract does not need to pay for the whole contract upfront; rather, they can make a small investment to stake a claim in the commodity. Investopedia gives an example to demonstrate this principle at work in the stock market: Say you have a contract valued at $350,000. This value of the contract, which trades on the CME, is derived from the level of the S&P 500; it is $250 times this level. If the S&P is at 1400, the value of the futures contract is $250 X 1400, which comes to $350,000. A person looking to initiate a trade on this contract does not need to pay the $350,000 upfront, however; they only need to post an initial margin of $21,875 (according to current CME exchange margin requirements).

Now, where leverage comes in: if the level of the S&P 500 happens to increase, then the value of the contract also goes up, and the investor makes a profit. In the example given, if the S&P rises to 1500, then the contract increases its value to $375,000, and the investor makes a $25,000 profit off their initial investment.

The investor also has a chance of losing money if the S&P falls and being hit with a margin call, requiring them to deposit more funds into their account to bring the balance back up, so risk is involved. Nevertheless, the chance of making such a large profit with a relatively small investment (leverage) is what makes futures trading so appealing.

Next time, I’ll go into more detail on the risk involved with futures trading.

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