Key takeaways
- Futures are financial contracts that represent an agreement by investors to buy or sell a specific asset at a price and date in the future.
- The futures market is volatile and open to unexpected changes. Hence, it requires strict monitoring to avoid losses.
- It is generally advisable that experienced professionals trade and invest in futures because they understand the market.
Jump to a section
- What are futures?
- How to invest in futures
- Advantages of futures trading
- Disadvantages of future trading
- Future trading FAQs
What are futures?
Futures are financial contracts that represent an agreement to buy or sell a specific asset at a predetermined price and date in the future. The asset can be anything from commodities such as gold or oil to financial instruments such as currencies, stock indices, or individual stocks.
Futures trading allows investors and traders to hedge against price fluctuations, speculate on price movements, and manage risk. It can be used to lock in a price for an asset in the future, which can be beneficial for businesses that rely on a particular commodity or raw material.
Futures trading explained in simple terms
Imagine you own a restaurant business, and you sell food to people at an average of N1,000 per plate. But you notice that sometimes the price of rice, which you need to make your food, goes up and down depending on the season.
So, to make sure you can keep selling food at N1,000 per plate, you decide to make a deal with a rice farmer. You tell the farmer that you will buy a certain amount of rice from them at a fixed price, say N20,000 for a bag of rice. This deal is called a “futures contract”.
Now, even if the price of rice goes up in the future, you know that you can still buy them at the price you agreed upon with the farmer. And if the price of rice goes down, you might end up paying more, but at least you know you won’t be losing money by selling your food for less than what it now costs to make it.
Futures trading is kind of like that rice deal, but instead of rice, people buy and sell contracts for things like stocks, commodities and currencies.
How to invest in futures
1. Research the market
Investing in futures is not like other kinds of investments. It is important to study the market to know how it works and the risks associated with it.
2. Open a futures trading account
After understanding the market, open an account. You cannot invest in futures without a futures trading account. With the services of a brokerage firm, you can set up a trading account.
3. Select a futures market to invest in
There are different types of futures contracts in the market. It is advisable to pick the industries you are interested in or already familiar with. It could be energy, agriculture, stocks, oil, gold, etc. Being in the market also requires you to keep learning about the latest developments.
4. Choose an investment strategy
Investment strategies are not foolproof and carry varying levels of risk. It’s always advisable to do your research and consult with a financial advisor before making any investment decisions.
5. Place your futures trade and manage it
The market is volatile and prices fluctuate from time to time. Keep an eye on the market and ensure that your investments are safe. Know how to manage your investments when the prices are against you.
Advantages of futures trading
- Risk management: Futures contracts allow traders and investors to hedge against the risk of price volatility. For example, a farmer can sell futures contracts to lock in a price for their crops before they are harvested, reducing the risk of a price decline in the future.
- Leverage: Futures trading offers the potential for high returns with a relatively small amount of capital. This is because futures contracts are highly leveraged, meaning that traders can control a large amount of an asset with a relatively small investment.
- Liquidity: Futures markets are highly liquid. There are always buyers and sellers available to trade with. This makes it easy for traders to enter and leave positions quickly.
- Price transparency: Futures markets are highly transparent, with real-time price quotes and volume data available to all participants. This makes it easy for traders to monitor market trends and make informed trading decisions.
- Diversification: Futures trading offers the ability to diversify portfolios beyond traditional stocks and bonds. This can help investors reduce their overall portfolio risk and potentially increase their returns.
Disadvantages of future trading
- High risk: Prices can be highly volatile and subject to sudden and unexpected changes. This can result in significant losses for traders who are not properly prepared or who do not manage their risk effectively.
- Margin requirements: Futures contracts are highly leveraged— and this also means that traders need to meet strict margin requirements, which can result in additional costs and risks.
- Contract size: Futures contracts are standardized, meaning that they have a set contract size and expiration date. This can make it difficult for traders to customize their positions to match specific needs or investment goals.
- Counterparty risk: Futures contracts are traded on exchanges, which act as intermediaries between buyers and sellers. While exchanges are highly regulated and secure, there is always a risk that a counterparty will default on its obligations, resulting in financial losses for the other party.
- Market volatility: Futures markets can be highly volatile, with prices fluctuating rapidly in response to economic, political, or other external factors. This can make it difficult for traders to predict market movements.
Can beginners trade in futures?
Futures trading requires some level of expertise and it is not advisable for a beginner trader with no technical knowledge to start trading. It is okay to do research and learn about the market from professionals. After you’ve got a good grasp of the market, you can begin your investment journey.
How do you make money from futures?
You can make money from futures by buying and selling assets as it benefits and increases your portfolio value.
Who should invest in futures?
Investing in futures is generally more suitable for experienced investors who have an adequate understanding of the market and the risks involved.
Bottom Line
Futures trading can be complex and bring significant risks, including the potential to lose an entire investment. This is why it is crucial to understand the risks and do your research before investing. Don’t forget to seek the advice of a financial advisor before making any investment decisions.
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