It seems since lockdown. We’ve all wondered if it’s possible to make money online trading. Or maybe trading fills the need for excitement, the dopamine rush of a win. Whatever the motivation, it’s clear we’re all logging on for trade. With companies like Robinhood, it’s never been easier or cheaper.
The futures market is one of the most profitable markets to trade. Futures may be traded on margin, and as such, it magnifies investors’ returns on capital. Trading the futures is, however, a high risk. Losses mount quickly when a trade moves against a trader.
In this post, you’ll learn what futures are and why futures trading is the most profitable market to trade. You’ll also learn why it is so risky.
What Is The Futures Market?
Futures contracts were initially developed for the commodities market—oil, Corn, Wheat, Sugar, Coffee, Cattle, etc. Contracts are legally binding agreements that require a seller to supply a quantity of a specified commodity by a specific date. Similarly, the buyer is legally bound to pay the set contract price.
By contract, the buyer and seller have to lock in the future price. There are significant advantages to both parties. Consider the farmer’s point of view. Selling the crop before it’s harvested means the farmer is guaranteed the price negotiated and contracted. The farmer only risks losing out on any potential price gain above the contract price.
From the buyer’s point of view, knowing the cost of a major input ahead of time alleviates price spikes and erratic profit margins. The buyer’s only risk is the potential of prices falling before the contract date, meaning the buyer could have bought the commodity cheaper.
Futures contracts are therefore primarily a tool to help both parties remove price risk from their businesses. Institutions and retail investors use futures to hedge their positions in the market. Heavily traded futures markets include the E Mini S&P and Crude oil.
Futures contracts don’t just cover commodities. They cover stocks and bonds too. And as a retail trader, it’s possible to get in on the action by trading contracts between buyers and sellers.
Why Are Futures So Profitable?
The reason the futures markets are so generous is that they’re risky. And the reason futures are risky is that not only does the price need to move in the correct direction, but it must do it before the contract date expires.
So unlike owning shares, where time is not your enemy, you might say you only need to roll a six. With futures, you are handed another dice. Now you need a pair of six’s. Sorry about the gambling analogy, but unless you have a depth of knowledge on the commodity or share, getting both to align is gambling.
The attraction of the futures is its profitability, and that’s made possible by leverage. A contract for oil may trade at, say, $65 (contract is set at 1000 barrels), which means the contract costs $65,000.
When trading an oil contract, brokers offer traders leverage that allows the buyer of the contract to put up as little as 5% of the cost. The trader is borrowing money from the broker and using the futures contract as collateral.
The trader may, for example, control 1000 barrels of oil for $3,250, The $3250 is known as margin, and buying a futures contract in this way is known as “Buying on margin.”
A trader’s account is adjusted up or down as per oil price (at end of the day), known as marked to market. Let’s assume oil moved to $66. A trader’s account is credited $1000.
When a contract is purchased on margin, a maintenance margin is applied to the account. Brokers require traders to maintain their account balance above a threshold (varies). These funds are available for drawdown should the contract price move into a loss.
To avoid taking delivery of 1000 barrels of oil, retail traders roll over their position or sell the contract outright. Contracts may be bought and sold at any time before expiration.
As such, a trader can sell the contract immediately and bank the profits. By the magic of leverage, in our example, an investment of $3250 returns $1000. Pretty profitable return on capital for one day, and oil regularly moves by $1 and more in a session.
But wow, there, it’s not all gravy! Leverage works the other way too. If the price moves against the trade, losses are heavy and can wipe out an account quickly.
Risky propositions should always pay more. The reasoning is simple. Only a percentage of trades are successful. The successful trades must be large enough to cover the losing trades.
Professional traders don’t look at each trade in isolation. They think in terms of the bigger picture, the next one hundred trades. They know their batting average, their risk-reward ratio, and most don’t risk more than 2-3% of their capital on any one trade.
A wise trader (Dave Roberts) told me his secret to success “Don’t Lose Money,” and by that, he means don’t lose your account to anyone trade. Not losing some money isn’t possible, but a trader’s job is to make excellent money management decisions. Dave added, focus on protecting your capital, and the results will follow.
Specializing in a particular commodity is an intelligent way to develop specialized knowledge. You’ll need an edge to tip the odds in your favor if you have industry knowledge. Great! That’s an edge that could propel you to the winner’s circle. Without a solid strategy, though, it’s rolling dice.
If you can trade futures successfully, there’s a cherry on this cake. Profits from futures trading attract preferential tax treatment. Nice!
Investing Is Less Risky Than Trading
Okay, so they’re risky, so what? The truth is, a beginner trader is not likely to succeed in trading futures contracts. Trading successfully is challenging to master and will require an investment of not just your money. It will require all your attention. It’s not practical to trade futures successfully part-time.
If you can’t commit to learning as much as you possibly can about a particular commodity, stock, etc., and become truly informed, then consider buy and hold investing instead.
Investing for the long haul is a far less risky venture. Buy and hold has served investors well in the long run, and if you’re young, the combination of reinvesting dividends and compounding will work like magic on your account. Several years out, you’ll look like a rock star!
I’m not a financial advisor and can’t tell you what stocks to buy. In my experience, it’s not the hot stocks of the minute that offer the best investments. I’ve had success buying shares in solid but boring businesses. They are often overlooked and, for that reason, provide excellent returns.
I look for a business with a solid performance record and earns a good return on capital without needing a ton of leverage. These types of companies are out there. They just need unearthing.
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