Futures Trading Strategies

Last Updated on July 18, 2022 by Oddmund Groette

The futures market is exciting because of its good liquidity, and unlike equity day trading, there is no reasonable entry barrier, as you can start with as low as $500. But what exactly are futures?

Futures are derivative financial contracts that obligate a trader to buy or sell an asset at a predetermined future date for a set price. When a futures contract expires, the buyer must buy and receive the underlying asset and the seller of the futures contract must provide and deliver the underlying asset, or the contract is settled with cash, regardless of the current market price at the expiration date.

What are futures?

Futures are derivative financial contracts that obligate a trader to buy or sell an asset at a predetermined future date for a set price. Similar to options, a futures contract involves both a buyer and a seller. But unlike options, which can become worthless at expiration, when a futures contract expires, the buyer is obligated to buy and receive the underlying asset and the seller of the futures contract is obligated to provide and deliver the underlying asset, regardless of the current market price at the expiration date. The underlying assets could be physical commodities or financial instruments.

Futures contracts are traded on futures exchanges like the CME Group. You would need to have a brokerage account that’s approved to trade futures before you can access the exchange. To facilitate trading on a futures exchange, futures contracts are standardized — each contract has details of the underlying asset.

Industry stakeholders and institutional investors may trade futures to hedge the future price risk of a commodity on their operations or investment portfolio. They trade futures with the intention to receive or deliver the underlying asset.

For retail traders and other speculative traders, futures are used for speculation since the market is generally liquid and can be bought and sold up to the time of expiration. Speculative traders buy or sell futures to potentially profit from the direction of the market for a commodity. Before the contract expires, they initiate the opposite position to close out their trade and eliminate any obligation to receive or deliver the underlying asset.

History of futures trading

The history of modern futures trading can be traced to 1730 when the Dojima Rice Exchange was established in Japan for the purpose of trading rice futures. In the West, commodity futures trading started in England during the 16th century, but it was not until 1877 that the London Metals and Market Exchange, the first official commodity trading exchange in England, was established.

Meanwhile, in the United States the earliest official commodity trading exchange, the Chicago Board of Trade (CBOT), was established in 1848. The first traded futures contracts in the U.S. were corn contracts, followed by wheat and soybeans — these three soft commodities still account for the bulk of trading business conducted at the CBOT.

Subsequently, the New York Cotton Exchange (NYCE) was created in 1870, and the Chicago Produce Exchange in 1874. Following World War 1, in 1919, the Chicago Butter and Egg Board reconstituted to become the Chicago Mercantile Exchange (CME), to offer public participation under carefully supervised commodity trading regulations.

The pros and cons of futures

Some of the pros of the futures market include:

  • Easy to access: The entry barrier is low, allowing investors to participate in markets they would otherwise not have access to.
  • High liquidity: Most futures markets have high liquidity, which enables traders to enter and exit the market when they wish to.
  • Hedging against future risks: Futures contracts are used as a hedging tool in markets with a high level of price fluctuations. For example, farmers use these contracts to protect themselves against the risk of a drop in crop prices.
  • Simple pricing: Unlike the extremely difficult options pricing models, futures pricing is quite easy to understand. It’s simply based on the cost of carrying to the spot price of the asset.
  • Stable margin requirements: Margin requirements for most assets in the futures market are known to traders.

Despite the merits, futures come with some demerits. Here are some of the cons:

  • Expiration dates: Future contracts have expiration dates, and the contract prices for the given assets can become less attractive as the expiration date draws nearer.
  • Leverage issues: Futures are leveraged instruments, and high leverage can lead to rapid fluctuations in futures prices.
  • No control over future events: You don’t have any control over future events, such as natural disasters, unexpected weather conditions, political issues, etc., which can completely disrupt the market. This exposes you to risks.

Relevant article

An option for futures trading strategies is ETF trading strategies. Normally, these two types of trading vehicles track the same asset but they are somewhat different:

Futures trading strategies

About 95% of the backtests on this website are tested on ETFs. It could be SPY, XLP, USO, TLT, for example. However, as a rule of thumb, the difference between a futures backtest and ETF backtest should be minimal in liquid assets.

At the end of the article we list a few examples of futures trading strategies in different asset classes:

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