When thinking about investing in futures trading, it’s important that you understand how things work in the stock markets. It’s true you’re determined about going into future trading but do you have the right understanding of what it means and how it works. You need all these pieces of information to succeed as you’re investing in futures trading.
If you’re clueless about all of this information, don’t panic as you’ll find out all there is to know about futures trading in this article.
What is trading Futures?
Futures are derivative financial contracts in which the sellers and buyers are mandated to transact an asset at a predetermined future date and price. By this, both parties are obligated to trade the underlying asset at the predetermined price, regardless of what the current market price might be at the expiration date.
When we talk about underlying assets, what are underlying assets? And, what do we mean by futures contracts?
Underlying assets are those financial instruments or physical commodities. By futures contracts, these entail the quantity of the underlying asset, which must be of a good standard so as to expedite trading on a futures exchange. One of the usefulness or benefits of futures is that it helps when it comes to trading speculating or hedging the trade.
What is Futures Market?
This is a type of auction market where the parties trade futures contracts and commodities and the delivery for these commodities or futures contracts are done on a predetermined future date.
Below are some common examples of futures markets:
- The Minneapolis Grain Exchange
- The Chicago Board of Trade (CBoT)
- The New York Mercantile Exchange (NYMEX)
- The Chicago Mercantile Exchange (CME)
- Chicago Board Options Exchange (CBOE)
- The Kansas City Board of Trade
How Do Futures Contracts Work?
How things work in futures contracts is that there is a legal agreement between the parties to secure a specific price and lock in the price till a specified time in the future.
A typical example is where a company needs to lock in the prices for a particular commodity asset so as to avoid an unexpected future increase in price. In this case, what the company will do is to buy a futures contract agreeing to buy the fuel at a specified amount and on an agreement that delivery will take place in the future at that specified price.
Using an example of a company trading in fuel, let’s now illustrate.
Assume a crude oil trader speculates on the price of fuel and, as such, decides to enter into a futures contract to lock in the price. By doing this, he could decide to enter into the futures contracts in September, for example, expecting that the price will go up by the end of the year.
At the end of this agreement, both parties come to the conclusion to buy (or sell) 2 million gallons of fuel, expecting the delivery to take place in 90 days, at the price of $5 per gallon.
From this example, we can conclude that both the seller and the buyers are hedgers as both are looking for an opportunity to avoid the risk of an unexpected price hike.
However, it’s worth mentioning here that sometimes if not in most cases not all companies will be ready to exchange their commodities on an agreement of locking in the price now and then delivering in the future at that specified price.
The thing is if eventually, the price of the product (fuel) goes up as speculated, it pays off for the owner of the contract as s/he can sell for a higher price in the future market. All in all, traders in this type of market are most times people who are looking for the opportunity to bet on changes.
Understanding How Fair Value of Stock Market Futures Are Calculated
If you’re wondering what fair value is, it’s the sale price agreed on by a willing buyer and seller at an arm’s length transaction.
If you’re planning to trade in market futures it’s important for you to understand how the fair value of the stock market is being calculated. Getting the fair value of market futures is broadcasted on many business channels and in a pre-market manner. By this, it means each morning before the market begins fair values of market futures are mentioned. What determines the fair value are the expected price of the market futures contract and the current value of the underlying index.
The formula for calculating fair value is given as follows:
Fair value = Cash X (1+ r (x/360)) – Dividends.
- Cash stands for current S & P cash value
- r stand s for interest rate
- x stands days to when the futures contract will expire
- Dividends stand for dividends of all the S&P 500 to the contract expiration
Future trading can be your best shot at potentially creating profits that will be worth your time and efforts, it’s important you understand how it works. Because if markets move against you and your speculations fail, you could lose more money than you invested. So take your time to get all the tips and tricks in futures trading before taking the leap.