Pros and Cons of Futures Trading

Futures trading can offer the experienced investor amplified returns on investment. Traders who can tolerate risk can trade futures to grow their wealth. Futures traders traditionally use generously leveraged positions, allowing greater exposure to the market than their capital would otherwise allow. Highly leveraged positions allow traders to maximize profit. It also exposes them to a higher risk of loss.

Investing in futures comes with benefits and drawbacks. Read on the learn more about the risk and rewards of trading futures.

What is Futures Trading?

Futures trading is an investment strategy that involves buying and selling contracts for future delivery of a commodity, security or currency at a predetermined price. It is a highly speculative form of trading and can be used to speculate on the direction of markets, hedge against risk or as part of one’s portfolio diversification strategy.

To trade futures, investors purchase contracts that represent a certain quantity and quality of the underlying asset at a predetermined price on a specified future date. The contract does not involve ownership, but rather, an agreement to buy or sell the asset on that date. Futures contracts are traded on exchanges such as the Chicago Mercantile Exchange (CME).

Benefits of Futures Investing

Futures investing offers opportunities for profit in a diversified investment portfolio.

Leverage

Futures contracts give traders exposure to a large amount of a commodity or financial instrument with a relatively small amount of capital. Traders can leverage futures trades by up to 90%, meaning they can open much larger positions than they could with their own capital. The profit potential of a leveraged position is amplified, but so are the risks, so futures traders must have a risk management plan in place.  

Liquidity

Futures markets are highly liquid. Traders can quickly enter and exit trades. High trade volumes allow futures traders to concentrate on the timing for the best returns. Futures markets are also transparent and well-regulated. 

A Hedge Against Price Changes

In industries where price changes are frequent, futures trading offers traders insurance against price changes. Farmers sell their products ahead of the harvest to ensure they get their needed price when the harvest is ready for sale. Farmers only receive the proceeds when the crops are delivered, but the futures contract protects them from price changes.  

Risk Mitigation

Forward contracts are commonly seen in foreign currency purchases by businesses that operate across international borders. Cross-border trade exposes companies to the risk of exchange rate losses. Such companies avoid the risk by buying forward contracts, pinning the price at the current exchange rate.

Diversification

Futures contracts for a vast range of financial assets, from commodities to currencies, are traded on the futures market. This practice allows traders to diversify their futures portfolios to reduce risk. Traders use advanced trading strategies to identify price discrepancies in closely related products, taking simultaneous long and short positions to offset the losses on one contract against the profits on another.  

Low Barriers to Entry

Flexible contract sizes mean that you don’t need vast sums of money to start your futures investment journey. Transaction fees are also low at between $0.25 and $1.00. Traders can make many trades each day without incurring hefty fees. It is also easy to access the futures markets using investment apps or trading platforms. 

Drawbacks of Futures Investing

Like most investments, futures investments have potential disadvantages.

High Risk

Traders have no control over what happens in the future. Political instability, economic meltdowns and natural disasters can quickly affect the price of commodities and cause large, unexpected losses. Leverage can amplify these losses, so traders should be aware of the potential risks involved. 

Complexity

Futures trading can be complex and successful traders must have extensive market knowledge. Markets are open around the clock, and trading can take a lot of time. Successful traders must stay abreast of global changes and track price trends to maximize profits. Many traders close their positions in their futures portfolio at the end of the day to avoid overnight losses. 

Volatility

Futures markets can be highly volatile, making it difficult to predict price movements and manage risk. Volatility is the degree to which processes move around an average. Price volatility in the futures market is caused by issues that influence the prices of the underlying assets. 

Leverage and Margin Calls

Leverage works both ways. It offers traders an opportunity to maximize profits on their futures portfolio, but it also amplifies losses. Traders who lose money must pay it back. Losses may be more painful for traders accustomed to the higher maintenance margin of 25% to 40% of stocks. Futures contracts may require as little as a 3% maintenance margin. 

When the value of a trader's account falls below a certain level, the broker will issue a margin call. A margin call requires the trader to deposit additional funds into the account or close out positions. Check your broker's margin requirements before trading.

Expiration Dates

All futures contracts have an end date, otherwise known as the expiration date. It is the last day on which the contract is valid. As the expiration date approaches, futures contracts often become less attractive. Toward the end, the futures contract may lose all of its worth. 

Futures May not Have SIPC Insurance

The Securities Investor Protection Corporation (SIPC), insuring most brokered investments, doesn’t insure for a loss in value for futures contracts. It also doesn’t cover most commodity futures. 

Open a Futures Trading Account Today

If you’re evaluating your long-term investment strategies, you’ll want to consider all your options and weigh the pros and cons. Benzinga's insights and reviews can help you make the best choices to fulfill your long-term financial objectives. Explore futures brokers to make informed choices that suit your risk tolerance, market knowledge and budget. 

Start Investing in Your Future

When it comes to investing in futures, there are both pros and cons. On the plus side, futures trading can be a great way to take advantage of price movements in the market, as well as leverage your investments. Additionally, since futures contracts are standardized and highly regulated, they can be a relatively safe way to invest compared to other forms of speculation.

On the downside, however, futures trading is a highly complex and risky form of investing, so it should only be done with experienced investors who have the necessary knowledge and expertise. Since futures contracts are leveraged investments, investors can suffer significant losses if they are not careful. All in all, the pros and cons of futures investing depend on an individual’s goals and risk tolerance.

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