When a trader trades stocks or options on stocks they use tools like technical and fundamental analysis in trying to determine what a stock will be worth in the near term or longer term future. The obvious point is to buy at a low price and profit when the price goes up or sell at a high price and profit when the prices goes down. This is done directly or by using options contracts to hedge risk and leverage trading capital. Another way to look for profit in the market is to buy or sell futures. Why trade futures when you can trade or invest directly on one hand or use options to hedge risk on the other?
What Are Futures?
A future is a derivative contract (like an option). Unlike an option where the buyer has the right to execute a contract but not the obligation, with a future contract both buyer and seller are obligated to buy or sell the asset in question at a price set by the contract on a specific date, the expiration date of the contract. As with options, traders commonly exit their contract before expiration taking their profit or absorbing their loss rather than taking or making delivery of assets such as live cattle, crude oil, or gold bullion.
Why Can Futures Be Attractive?
Futures are commonly used by businesses that deal in commodities in order to hedge risk. Speculators trade the same futures contracts in hopes of profiting from what are sometimes impressive price swings. The ability to hedge risk is generally why a gold mining company or an oil company may buy or sell futures. Relatively easy pricing and high liquidity aspects of futures are the features that attract traders. In addition, there are tax advantages in trading futures and the fact that there is no pattern day trader regulation in trading futures.
Cash Settlement or Delivery of an Asset in Futures Trading
Whether a futures contract is settled for cash is determined by the person in the “short” position, the person who is obligated to deliver the asset in question. They send a “Notice of Intention to Deliver” to the futures exchange. Because of the risk of having to accept boxcar loads of live cattle or a tanker full of oil, the buyer of the option contract in question exits their position before settlement to avoid this potentially difficult situation. Otherwise futures trading resembles options trading or trading stocks directly in that the trader establishes and funds a margin account which limits how much they can risk in a trade. As with other forms of trading, if a trade goes badly, a person may be required to add money to their margin account to cover their losses. Unlike with options trading, a futures trader is not setting up a trade with a strategy that hedges their risk unless they trade options on futures.
Trading Options on Futures
The way that a trader can hedge their risk in trading futures is to use standard options contracts just like they will use when trading stock options. A trader can buy or sell calls or puts on either long or short positions in a futures contract. As with setting up hedging strategies in stock options, hedged strategies in options trading typically limit the potential return on a trade in return for limiting the risk. As with stock options, the value of a futures option contract will fluctuate with the value of the underlying asset.
Predicting Futures Values
When trading futures a trader considers the same factors that he or she considers when trading stocks or stock options. What is current market sentiment as reflected in technical indicators and what are the underlying fundamentals that will drive the price of the underlying asset in the days, weeks, and months to come. The same rationale for trading stock options applies to trading futures options. A futures options trader can turn on a dime and potentially profit no matter which way the market is headed and hedge their risk on every single trade.