Most Effective Futures Trading Strategies You Should Try

Most Effective Futures Trading Strategies You Should Try

There are different markets in the financial world, and each of them offers various methods and strategies for the traders. One of the most common methods you can find in the financial field is the futures trading.

Futures trading have been around for years. It was originally created to help support the farmers during time of planting and harvest. It now serves numerous purposes and is used by almost every trader and investor in the field. These traders have also developed different strategies that will suit their needs.

Today, we will be discussing what exactly a futures contract is, as well as the various futures trading strategies being used in the financial field.

FSMSmart - Futures in a chart next to an arrow pointing up indicating increase

 

What is a Futures Contract

A futures contract is basically an agreement made between two parties – the buyer and the seller. The agreement indicates whether an asset will be bought or sold at a specific time and price in the future. Every future contract has an indication of a specific amount of a given security or commodity. A futures contract bears similarities to options contracts in many ways, mostly in their usefulness when hedging or speculating.

One of the most popular futures contract in the field is crude oil. It has a contract unit of 1,000 barrels. On the other hand, a futures contract of corn signifies 5,000 bushels (around 127 metric tons of corn).

The futures contracts were originally made to give farmers the opportunity to hedge against any possible changes in the prices of their crops. These changes can happen between the time of planting and the estimated time of harvest and delivery to the market.

In this day and age, producers and end users still use futures to hedge against risk. This, though, is no longer its sole function. Investors and traders of all types use futures contracts with the purpose of speculation. They generate profits by betting on the direction that the asset will take.

The first futures contracts were focused on agricultural commodities like livestock and grains. Nowadays, the market has contracts linked to a wide variety of assets. These include precious metals (gold), industrial metals (aluminum), and energy (oil). Other assets are also present, such as bonds (Treasury bonds), and stocks (S&P 500). These contracts have become standardized over time and now trade on future exchanges around the world. Some of the exchanges are the Chicago Mercantile Exchange (CME), and the Intercontinental Exchange (ICE) in the United States.

Futures Trading Strategies

1.      Long and Short Trades

There are 2 different directions you can take when entering the market. The direction you take depends on where you expect the market to go. No matter what direction you decide to take, you still need to come prepared. Ensure you have a large enough balance in your trading account to meet the initial margin requirement for the contract.

Long Trades

These are the classic method of buying; intending to profit from a rising market. Losses in long trades could be extensive, but are still considered limited. This is mostly due to prices reaching as low as $0, and no further, if the trade goes against you.

Short Trades

When entering short trades, you have the clear intention of gaining profits from a failing market. Once the price reached your target level, you can then buy back the shares to replace the ones you originally borrowed from your broker.

Trading short futures is considered to be one of the integral parts of active trading. This is mainly because it gives you the opportunity to benefit from both rising and falling markets. Extra cautions should still be exercised since once the market rises, a short trade will begin losing its value.

Another difference short trades have from long trades is the potential for unlimited losses. Market prices can theoretically continue climbing indefinitely; therefore the value a short trade can potentially lose is also unlimited. This risk can be managed by using a protective stop-loss order.

Dollar bills surrounded by corn

2.      Spread Trading

Spread trading is also a common strategy that futures traders use. It makes use of both long and short positions at the same time; entered in related futures contracts. Traders who use this strategy aim to gain profit from the price difference between the two contracts. Other than this, it also allows hedging against the potential risks.

Additionally, in this strategy, you’re speculating the risk of the difference between the two contracts instead of a single contract. This is why spread trading is considered to be a less risky option than taking an outright futures position.

For example, let’s assume that you decide to put a spread in oil. If the prices of oil increase, the resulting gain will be able to offset the loss from the short one. The opposite happens in case the oil prices fall.

Types of Spreads

spread trading infographic

·         Bear Futures Spreads

Traders using the bear futures spread enter short trades the near month and long trades the deferred months. It’s basically the opposite of the Bull Futures Spread. For instance, it’s April 2018. You sell July 2018 Gold and buy September 2018 Gold. You will be taking a short position for the closer month and a long position for the deferred month. This is considered as a bear spread because the near months tend to move faster and farther than deferred months. A bear futures spread mostly tend to go in your favor during times when the prices are falling.

·         Bull Futures Spreads

A bull futures spread is being used when a trader is long the near month and short the deferred month in the same market. It’s basically the opposite of a bear futures spread. Again, for example, it’s April 2018. You buy July 2018 Gold and sell September 2018 Gold. You’ll be taking a long position for the closer month and a short position for the deferred month. You should remember that the closer months usually move farther and faster than the later months. Bear futures spreads will most likely go your way when prices are climbing.

·         Calendar Spreads

This spread consists of buying and selling two contracts of the same type and price at the same time. These contracts vary in terms of having different delivery dates. Calendar spreads are most commonly used in the grain markets. This is due to the seasonal factor of planting and harvesting. An example of this spread would be selling a July contract for corn and then buying the December contract simultaneously.

·         Inter-Exchange Spreads

This includes any type of spread as long as each position is created in a different futures exchange. For example, buying one contract on CBOT and selling one on NYMEX.

·         Intermarket Spreads or Inter-Commodity Spreads

When using this type of spread, you buy and sell different spreads, though they are most often still related. Additionally, these contracts must have the same expiration month. An example of this will be Corn versus Wheat. Now let’s say that the trader expects the Corn market to have higher demand than the Wheat market. The trader then buys Corn and sells Wheat with the sole purpose of seeing the price of Corn appreciate over the price of Wheat.

How to Trade Futures

There are different approaches you can take when entering the futures market. Here are some of them:

·         Open a Managed Account

You can choose to open a managed account, which is similar to an equity account. Your broker will have the power to trade on your behalf. There are pre-set conditions agreed upon when the account was first opened. With this method, the potential financial risk could be lessened since a professional will be the one making the decisions for you.

It’s still important to remember that you will still be the one responsible for any losses incurred. The margin calls also fall under your responsibility. Moreover, you might need to pay a management fee for the service.

Broker and client discussing a contract over a table

·         Join a Commodity Pool

This is the approach that offers the least risk. A commodity pool is an enterprise where funds contributed by a group of investors are combined to use for trading futures. The amount of loss you incur is directly proportionate to the amount of money you invest.

·         Do It Yourself

Then there’s always the option to trade your account on your own without aid or advice from a broker. This, though, involves the most risk since you alone is responsible for managing funds, ordering trades, and maintaining margins. You’re also responsible for acquiring research and coming up with your own analysis of the market trend in relation to the commodity or underlying financial instrument you’re invested in. this approach requires time and your complete attention to the market.

Conclusion

You should still note that futures trading are not for everyone. You can use futures trading as a way to hedge your other investments but they are also used for speculation. Using futures trading and futures trading strategies entails potential for both large rewards and large losses due to leverage.

Before making the final decision to trade futures, do your homework first. Make sure you first understand how the market and contracts function. Additionally, you must determine the amount of time, attention, and research you can actually allot to the investment. Not to mention the risks that comes along with it. Seek out the help of your broker before entering the futures market.

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