The Basics of Investing in Futures

Investing in futures can be an excellent way to diversify an investment portfolio, but it involves high risks and is not a good fit for everyone. However, many investors should give some serious consideration to taking a small portion of their portfolio and trying some speculation in the futures market. Most experts recommend no more than a five to ten percent allocation for this type of investing.

What are futures?

Many investors may have heard about futures, but they do not have a clear idea of exactly what they are or how to invest in these instruments. These are contracts which enable the holder to buy or sell a specific quantity of an item at a specific price. There is usually a time limit on the contract. Futures contracts are available on commodities such as gold, crude oil, natural gas, agricultural products (cattle, corn, and wheat) and many more.

Who is involved in the futures market?

A large section of the major players in these markets is commercial users of the commodities. For example, a major cereal company may buy and sell contracts of wheat and corn on a regular basis. These participants are simply trying to hedge. They want to have a guaranteed price for their commodities in the future and/or protect themselves from changes in prices.

There are also many individual investors or speculators who participate in the futures markets. They are hoping to profit from changes in the prices of the contracts. Speculators will always close out their positions before the contract is due and never take physical delivery of the commodity itself.

Another very specialized type of speculator is the floor trader. This group of people is probably the least well known of all investors, yet they serve a very important function. Typically, they will be trading for their own account, but are on the floor to help provide liquidity in the market. When there is no one willing to take the other side of trade, these folks will, hoping to have the chance later to sell (or buy) for a small (or large) profit.

Incidentally, many mutual fund managers are also involved in these markets. They will typically use futures contracts on stock market indexes in an effort to manage their risk.

Basic futures strategies

The most basic way to make money with futures is buying (going long) in the hope of a future price increase. If the analysis is correct, sell the contract at a later time (but before the contract itself expires) for a profit.

If an investor or speculator believes the price of an underlying commodity or index will decline in price, then they may sell short a futures contract. It is very easy to do this with futures contracts; the only difference is the sequence of trades. Instead of buying a contract, the initial move is to sell. The position is closed by buying the contract back before it expires (the two trades cancel each other out). If the price has declined the speculator will make a profit.

Beyond these two basic strategies, there are a number of advanced trades and techniques which can be used. These are all very similar to option trading, since futures contracts act almost exactly like options. These include spreads and straddles and can become very complex.

What types of investors should use futures?

The ideal profile of a futures investor is someone who has a solid tolerance for risk. This type of investing should probably not be undertaken by a beginning investor. It is recommended that only seasoned and experienced investors attempt any of these strategies, since they do involve a fairly high amount of risk.

A person with a good sized and stable portfolio may wish to consider allocating a small amount of money to this strategy. Most experts would not advise more than five or ten percent (at most). This should be money that would not affect lifestyle or level of comfort if much of it was eventually lost.

An investor who may be unhappy with their current level of returns may be interested in further examining this type of investing and speculating. Futures can be a great way of injecting some new life into an otherwise stagnant investment portfolio.

Final notes and warnings

Futures contracts involve a large amount of leverage as well. A single contract can control a huge amount of an actual underlying commodity. For example, a single corn futures contract controls 5,000 bushels of corn. Speculators do not need to put up all the money at once. At the same time, this may lead to investors being required to put up more money for a margin call if prices move against them.

Anyone seriously interested in such investing and speculating should take enough time to thoroughly understand how these instruments work and feel totally comfortable with the level of risk involved. They are certainly not for the faint of heart, but can be some incredibly profitable vehicles.

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