How to Make Money Trading Futures
Trading futures gives traders the opportunity to speculate or hedge against the risk of a price movement in an underlying asset. These assets can be a commodity, index or currency.
Many businesses trade commodities, such as hog farmers or oil refiners who hedge to protect against unfavorable prices in the market. Others simply use futures to capitalize on price movements.
Liquidity is the ability for an asset to be bought and sold in a timely manner with minimal market impact. Market liquidity manifests itself in high trading volume and tight bid-ask spreads.
The most liquid assets include stocks of publicly traded companies, commodity futures contracts such as oil or corn, U.S. Treasury bonds, and currencies such as the USD or EUR.
Most trading platforms display the depth of the market, which shows how many contracts traders are willing to buy (bid) and sell (ask). Deep markets feature heavy participation from a variety of firms. This promotes trade-related efficiencies and minimizes pricing volatility. They are also target-rich environments for active traders. These conditions are reflected in the metrics of average daily volume and open interest.
Volatility is the degree to which a market moves, and it’s an important factor when trading futures. It helps traders gauge investor sentiment and determine market direction. It also plays a role in the pricing of options contracts.
Higher volatility means that gains and losses are magnified, so it’s essential to have a strong game plan and consistent strategy before trading high volatility stocks. This is why most newbies are best off sticking to medium volatility stocks until they gain experience and confidence.
It’s important to remember that investing is a long-haul game, and periods of volatility actually provide opportunities for investors to purchase stocks at lower prices. This can help mitigate the impact of market corrections on a portfolio’s overall returns.
Prediction markets, also called information markets, event derivatives and idea futures, aggregate beliefs about an unknown outcome. They trade on contracts that have payoffs ranging from 0 to 100%. In the case of index futures, traders believe the index will be higher or lower than its current price.
If index futures are trading above fair value, for example, and good news comes out of Europe overnight, it may suggest the US market will open higher than expected. However, index arbitrageurs don’t trade before New York opens, so the futures signal is only useful for a short time. Similarly, when several big index constituents go ex-dividend, futures prices indicate a lower opening. Prediction markets have proved more accurate than analysts on election outcomes, for example, and Hollywood box office success.
Leverage allows you to control a larger position with only a fractional cash deposit called margin. This can be a great benefit when making profit, but can also wipe you out quickly with a large loss.
Leverage is a key component of trading futures. Traders use it to magnify their potential profits, but it can also amplify losses if they lose money on a trade. To avoid losing their entire capital, traders must carefully monitor their risk and follow a solid money management plan. For example, they must always keep enough margin in their account to avoid a liquidation call from the broker. This includes knowing when to stop trading, and when to scale back their positions. They must also avoid over-margining themselves, as this can lead to negative effects.
Margin is a good-faith deposit required to control a futures contract. The margin deposit allows traders to leverage their investments.
The initial margin is set by the exchange and comprises two components: SPAN margin and Exposure margin. The latter is the margin blocked over and above SPAN to cushion for MTM losses.
If the value of a futures contract drops below the initial margin level, the broker will call for additional money. Failure to post this amount will result in the liquidation of the trade.
The margin requirements for futures contracts differ from those of stocks. These differences are due to different market conditions and risks associated with the underlying assets. Identifying these differences could help you decide whether futures trading is right for you.