How to trade futures? Here is some advice.
The oldest form of trading gets a technology facelift.
The concept of futures trading is as timeless as the marketplace itself. As long as people have been selling such tangible assets as oil, wheat or gold, there have been hedgers who want to protect against the possibility of a future price change and speculators who hope to profit if the hedgers are wrong. So, let’s talk about how to trade futures.
A producer of wheat, oil or another commodity, rather than simply bringing his product to market and taking his chances with willing buyers on delivery day, can hedge by agreeing today to sell his product at a specified price on that future date. Futures speculators buy up the risk that is offloaded by the hedgers; they make a profit if the price moves in a direction different than the hedger anticipates and in addition they now own a fungible commodity they can sell at any time until the delivery date to take advantage of market change over time.
The symbiotic relationship of buyer and seller ensures the liquidity of the marketplace and that capital flows smoothly while providing a “discoverable” price for any commodity at any given point in time. And that’s the way futures trading has operated for centuries… until today.
Electronic futures trading in the 21st century:
Much futures trading is still done with the traditional “open outcry” method in public pits. But traditional trading is giving way to electronic transactions in which a wide variety of indexes—representing everything from basic commodities to the S&P 500—can be traded online 24 hours a day and 5 days a week, using strategies that take full advantage of the skills taught at Online Trading Academy.
Achieving dramatic results in futures trading through high amounts of leverage:
The majority of Futures traders maintain a margin account with their brokers, which allows them to magnify their results through leverage. Unlike Stock trading in which the margin account is an actual loan, in Futures trading the margin is the equivalent of a “handshake” or good faith agreement.
In order to open a Futures position the trader has to have on deposit with his broker an initial margin amount that is set by the exchanges. This amount is typically 5-13% of the Futures contract face value. Think of this initial margin as a down payment when you purchase a house. You put down 20% to control the full market value of your home.
While holding these Futures positions you must keep your account balance at a level that meets the maintenance margin amount. These maintenance margin amounts are usually about 25% of the initial margin. If your position goes against you causing your account balance to fall below these levels you will receive a margin call to replenish the account value back to the initial margin or else the brokerage will liquidate your position at the market if you do not comply.
The Futures trader now has the equivalent of approximately 10:1 leverage or higher, for each Futures transaction. The smaller the margin is in relation to the underlying market value of the Futures contract, the greater the leverage.
Let’s look at an example of this leverage at work. On August 18, 2009 the S&P E-mini is trading at 980.00. To compute the market value you take the dollar value per point ($50 per E-mini point) and multiply it by the last price. 980.00 X $50 = $49,000. The current initial margin set by the Chicago Mercantile Exchange (as of 8/18/2009) is $5,625. For $5,625 you can control a Futures contract worth $49,000! That is about 9:1 leverage. For every $9 the contract is worth you are depositing $1.
More factors that make futures attractive to aggressive individual traders:
Impressive leverage is one reason that futures trading appeals to investors who want to control significant assets for a small amount of capital. Another benefit is the tax advantage. The government is eager to encourage the healthy activity that futures trading brings to the marketplace. Thus, futures profits get favorable tax treatment with the first 60% of your profits taxed as long term gains, regardless of when they are realized. (This certainly makes sense because a tax-motivated trade would be contradictory to the smooth flow of commodities trading.) And with the maximum tax rate now at 15% for long term gains vs. 28% for short term gains, here’s yet another way your potential gains are increased when you trade futures.
A final benefit is that futures is a highly regulated marketplace—built for commodities traders while open to speculators. In general broker fees are transparent and services consistent from one broker to another. And small as well as large traders can be confident of fair treatment.