Disclaimer: If you don’t like risk, futures trading may not be for you. But if you want to play it safe, futures trading may be for you. Does that makes sense? No? Welcome to the world of futures trading.
This is a big world, so I’ll start with the basics. Don’t worry—futures trading does make sense; otherwise people wouldn’t do it. Futures are standardized contracts. A futures contract states you intend to buy or sell something at a certain time in the future. Once you buy a futures contract, its value will go up or down based on the market value of what you’re intending to buy or sell.
If you buy a futures contract for a certain brand of dog bones because they’re worth $5 per bone right now, but six months in the future you expect them to be worth $15 per bone, and that value projection does indeed pan out, then you win. That’s the most elementary explanation of futures trading. Read on to find out more.
How Futures Trading Applies to You
You’re young, you don’t have a ton of money, and you’re wondering how on Earth this applies to you. Why would you spend money on a speculative contract? Why would you make a cash wager on the future value of a commodity, stock or foreign currency?
There are multiple instances in which futures trading could be a very good idea. Say, for example, you inherit a sum of cash from a deceased relative. You’ve already paid off your student loans, or maybe you don’t have any to pay off. Your choice is either to spend the money, save it, or invest it.
You want to be smart with the money, so you decide the best course of action is to invest it. You’ve heard that buying a house is better than investing in gold, but you look at the price of gold right now, and note it’s on an upward trend. Furthermore, there’s a high level of uncertainty about where the dollar is headed because of current events, and you see that Chinese currency is strengthening against the dollar, to the tune of 3 percent.
You could simply go out and buy gold, because in the event that the dollar tanks, gold will give you a better return than a real estate investment. But according to Investopedia, “Because they trade at centralized exchanges, trading futures contracts offers more financial leverage, flexibility and financial integrity than trading the commodities themselves.”
In other words, if you invest in gold futures, it’s safer than buying gold straight up, because when you sell the gold, the price you get for it will depend on where you sell it and who you sell it to. Not so with a centralized exchange. On the centralized exchange, you buy or sell gold futures at the same rate, regardless of where you’re from. But here’s the clincher: as with any futures contract, a gold futures contract does not require you to have as much money as the gold itself is worth.
A gold futures contract gives you leverage. A single contract controls 100 “troy ounces” of gold (a troy ounce equals about 31 grams). As of this writing, a single gold futures contract is worth $129,000. The amount of money you must have to hold the gold futures contract is based on exchange margin rules. For a single contract, you only have to have $4,050. So, for $4,050, you could control $129,000 worth of gold. For every $1, you control nearly $32.
Let’s say your inheritance is $20,000, and you’re trying to choose between investing in gold or buying a house. You could take $4,050 of the $20,000 and invest it in gold futures. The remaining $15,950 will make for a solid down payment on a house. In this case, you’re using gold futures as a hedge against the dollar. If the value of the dollar goes down, you have a house to live in and gold futures that are worth a great deal on the exchange. If the value of the dollar goes up, the value of your real estate will appreciate.
In the case where you see the value of the dollar appreciating, you can offset your position by selling your gold futures. And, for the most part, when it comes to a commodity like gold, very rarely does a buy position result in the actual purchase of the commodity. To hedge against risk, investors take a short position, which is also called a sell position. They don’t just do this to hedge against risk; they do it when the sell position will net them a positive gain.
You can also invest in stock futures for less than it would cost to buy the actual stocks. To invest in stock, you have to have at least 50 percent of the stock’s value; to invest in futures, you can put up 10-15 percent of the contract’s value, sometimes less. You can make more money faster than you would investing in stocks, because futures appreciate faster on average.
The Risk of Futures
Futures prices can appreciate quickly, but they can also depreciate quickly. That means you can lose money very quickly if you don’t take a sell position at the right time. So, it’s important to know what you’re getting into and to watch the market. Do your research, diversify, and futures trading may very well be a big money-maker for you.