Futures complex financial instruments that less experienced investors initially struggle to understand. But they are simpler than they seem and trading them does not require years of experience in the stock and financial markets. What investors need to be successful at trading futures contracts for profit is a good, professional futures broker.
There are no standard fees and commissions charged by futures brokers so investors may need to explore all their options before deciding on a brokerage firm. Some brokers provide advice, research, and access to various stats and additional data, while others simply offer their clients a trading platform with some basic charts and a quote. To choose the most suitable broker, investors first need to understand the basics of the futures contracts – how they work, how they are traded, and what are the benefits and risks associated with trading them.
What Is the Futures Market?
A futures contract, simply known as futures, is a derivative financial instrument that is traded on exchanges and is available to all institutional and retail investors, speculators, and hedgers. The futures contract is a standardized contract for purchasing a specific quantity of an asset or almost any financial instrument at a specific price and date in the future. To put it simply, this is a contract between two parties who want to secure the price and delivery of a commodity, for instance, in the future.
The futures market is comprised of various futures exchanges around the world, some of them created as divisions of the larger stock exchanges. Among the largest and most important futures exchanges are the New York Mercantile Exchange (NYMEX), which focuses on trading commodity futures, and the London International Financial Futures and Options Exchange (LIFFE). The world’s largest stock futures exchange in terms of trading volume is the National Stock Exchange of India (NSE) in Mumbai, followed by JSE Limited in South Africa. JSE Limited is the largest and the oldest existing stock exchange in Africa.
How Do Futures Work?
With the futures contract, traders secure a specific price and protect themselves from possible price fluctuations in the future. For instance, a futures contract for aviation fuel could be signed between an airline and a fuel distributor – the two parties agree on a specific quantity, price, and date of delivery. A million gallons of fuel would be sold, for $4 per gallon, and the fuel would be delivered after 60 days.
As you can see, futures typically specify all important parameters of the contract:
- the quantity of goods to be delivered or covered
- the unit of measurement
- the specific date of delivery (physical or not)
- the price, as well as the currency and the currency units
- how the trade would be settled – physical delivery, cash settlement, etc.
- the quality or the specific type of the traded goods
Usually, futures are traded by two types of market participants – hedgers and speculators. The players from the fuel example are hedgers and they agree upon the physical delivery of the asset. Hedgers are usually producers or consumers of a certain commodity. Many of the traders on the market, however, are speculators – they simply buy and sell futures contracts, profiting from the change in the price of the contracts themselves. Since speculators do not intend to actually deliver or receive the asset, they need to make sure to close their positions before the expiry of the contract.
To access the market of futures contracts, traders need the services of futures brokers. Sometimes, these are brokerage firms, which specialize in the trading of this particular financial instrument. There are also some Forex brokers, which offer futures on commodities, stocks, metals, etc. When searching for a futures broker, investors should check whether the firm covers the specific markets they are interested in.
Another important participant in the futures trading is the clearing house, a financial institution, which monitors the trade of futures contracts. The clearing house guarantees that the contract will be fulfilled even if one of the parties in the deal fails to do what it previously had agreed upon. The clearing house acts as a counter-party in every futures trade – it acts as a buyer in the sale and as a seller in the purchase.
Margin and Leverage
Futures trading is conducted through leveraged positions, which means investors optimize their capital to open positions that they could not afford otherwise. Leverage is the capital borrowed from the broker to open a position – for instance, the leverage offered is 1:10, which means the broker allows investors to open a trade with capital that is up to 10 times their deposit. In stock trading and on the futures market, this is known as trading on a margin.
The leverage functions after a specific amount of money is deposited by the investor and the deposit is referred to as margin. The margin is the collateral investors are required to deposit to cover the risk. Clearing houses and brokers charge their clients margin, which is usually a percentage of the price of the futures contract.
Clearing houses or brokers charge two types of margin and one of them is the initial margin, i.e. the deposit investors are required to make to cover any possible future loss. The other type is called market-to-market margin and it is the difference between the cost of the position held by the investor and the actual market value of the position. Often, brokers charge maintenance margin, as well.
How to Choose a Futures Broker
To access the market for futures contracts, investors should carefully choose a broker who is fully authorized and registered to offer such financial services. Investors should also see whether the broker offers good margin and leverage, as well as a convenient trading platform that allows fast execution and mobile compatibility. Here are several things traders need to consider when choosing a good futures broker:
The process of choosing a suitable broker may be difficult and confusing, especially for less experienced traders. The first thing they should check is the legal aspect of the trade and, more specifically, whether the broker is, indeed authorized and a registered member of a futures exchange.
The broker should clearly specify which government agencies regulate its operations in every different country. For example, the futures markets are regulated by the Commodity Futures Trading Commission (CFTC) in the United States of America. The CFTC is an independent federal agency, which regulates the derivatives markets in the country, i.e. all futures, swaps, and some kinds of options. In the United Kingdom, the futures exchanges and brokers are regulated by the Financial Conduct Authority (FCA), while in Australia, this role was taken by the Australian Securities and Investments Commission (ASIC).
Typically, the equity market would allow traders to use a margin of up to 50%. However, when trading futures, the margin is much lower – usually between 2% and 13% of the total value of the contract. Many brokers post the margin requirements not in percentages but as fixed prices – they depend on a large number of factors, including the investor’s country of residence, the type of underlying asset being traded using a futures contract, etc.
The margin requirements are determined by the futures exchange itself and are based on risk-based algorithms. Investors should know, however, that leveraged positions always increase the risk. This is why some brokers offer stop losses and other types of investor fund protection.
Commissions and Fees
Futures trading is associated with various fees that are charged for different aspects of the trade and for different periods of time. Usually, the broker commission decreases when large volumes are being traded. However, there may be also exchange fees, regulatory and clearing fees, as well as overnight position fees.
Some brokers offer fixed prices per contract, while others have more complex pricing schemes. When choosing a futures broker, traders should look for firms that offer low fees and commissions but more importantly, they should look for a broker who has clearly defined fees and a transparent pricing system.
After stock and futures exchanges switched to electronic trading, the markets have become accessible to anyone. But to trade futures, investors need to do that on a modern, functional trading platform – software platforms facilitate the trade of various assets but they also provide research, analytic tools, education, customer service, etc.
There are various trading platforms allowing trade of futures contracts and the best ones should also support mobile use. The vast majority of trading platforms offered by brokers are available through fast and convenient mobile apps that can be found on the App Store and Google Play.
As we have mentioned already, investors who wish to access the futures market need a futures broker. This is why the customer support service is very important – after all, clients invest real money and are exposed to real market risk. If they encounter a problem, they should be able to contact their broker immediately – even if it is 2.00 am. All respected online brokers offer professional, multilingual customer support that is available 24/7.