A “Futures contract” is a legal agreement between two parties that agree the delivery, from one party to the other, of a specified quantity, of a specified asset, on a specified future date, at a price agreed on the moment of the trade execution. Futures contracts are exclusively exchange-traded (the equivalent OTC instrument is called a Forward). When opening either a long (buying) or short (selling) Futures position, the investor or trader becomes exposed to changes in the futures price and the position will incur profits or losses as a result of the movement in price. Futures trading is referred to as a “zero-sum game”, since for each trade there is a winner and a loser.
1. Initial Considerations
There are certain assumptions that a trader or investor must follow before trading Futures, being that a very important aspect is to understand how Futures work. We recommend going through our series of videos 10 Essential Risk Management Videos – Part 1 and 10 Essential Risk Management Videos – Part 2 for more information on Derivatives instruments. There are also a number of other free financial markets courses that will help you get started.
It is also a good idea to buy a few books and start from scratch. If you come from an Equities background (i.e. shares or stocks), entering into Derivatives might be overwhelming in the beginning. In general people think of Derivatives as high-risk, very complex instruments. However, among other objectives, Derivatives are designed to allow investors to hedge their risk. Of course the trader must know what he’s doing and follow strict risk management trading rules (read further in the Top 5 Risk Management Trading Rules).
There are very good books about this topic in Amazon. We highlight a few below:
- Options, Futures and Other Derivatives
- Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options (The Wiley Finance Series)
- Options, Futures, and Other Derivatives
- All About Derivatives Second Edition (All About Series)
- The Practical Guide to Wall Street: Equities and Derivatives (Wiley Finance)
- The Value of Uncertainty: Dealing with Risk in the Equity Derivatives Market
There are more books about Derivatives and Risk Management in our books section.
Observe closely the following critical considerations. These are valid for anyone trading with Futures:
- Up to 70% of new futures traders lose the totality of their capital (or close to it) within a year or less
- You can lose significantly more than what’s in your futures account (i.e. margin plus or minus any gains or losses that occur over the span of the futures contract(s))
- If your goal is to get rich quick, perhaps you should try another line of business. In general, a short term emotional-casino approach will lead you to big losses
- Start learning about Technical Analysis and Fundamental Analysis. These are key skills that successful Futures traders possess
- Familiarise yourself with the Futures Contracts Specifications website. It includes contract specifications for all North American-traded futures and commodities, sorted by sector and market
- Never make large trades and follow simple yet strict trading rules. Make sure you read “Top 5 Risk Management Trading Rules” and “How Much Risk Should I Take” for better understanding what’s at stake for you
2. Capital Management
Define a rigorous capital management policy and follow it. Keep speculative capital separate from investment capital and keep it to a minimum of the overall portfolio value. Additionally, make sure you are properly capitalised at all times. If you don’t have at least e.g. £10,000 that you can commit to a speculative view, then you will find yourself in a default position. Committing savings, retirement money, rent money, children college savings, etc. into speculative capital should be seen as prohibitive for any investor or trader.
3. Trading Limits
To ensure that you don’t lose your speculative capital, establish and follow trading limits for any Futures trade. For example, limit your downside to no more than 10% of your capital for amounts under £100,000; for amounts between £100,000 and £500,000, this percentage should be reduced 1% for every additional £100,000 down to 6% for £500,000; for accounts £1,000,000 +, 5% or less per trade should be risked.
Read more about trading limits here: “Top 5 Risk Management Trading Rules”
4. Diversify Your Portfolio
This is a common rule of thumb for investors trading across different asset classes i.e. – don’t put all eggs in the same basket. Diversify your risk among at least three or more not directly related markets. The more markets your trades are diversified across, the less volatile your portfolio will be, reducing the risk of incurring in total losses.
Never use maximum leverage as it might be necessary to cover idle funds in your futures account, cash and equivalents held in other accounts, etc. It is always a good rule to keep a large enough buffer to cover intraday volatility and limit moves. The size of the buffer will depend on the particular markets you trade and your risk management strategy. If you never want a margin call, then you must consider having a higher percentage of your funds in your futures account to be kept idle.