Futures trading is enormously popular among prop traders, day traders, and investors. That’s mainly due to the high leverage. With a margin of $500, you can often trade positions worth tens of thousands of dollars in futures contracts like the E-Mini S&P 500.
But what exactly is futures trading about, what should you know about the underlying assets, and how does futures trading work? That’s what you gonna find out in this article.
What Is Futures Trading?
Futures are contracts of underlying assets like commodities, securities, or many other financial instruments. If you trade a futures contract, you’ll have to buy or sell the related underlying asset at an expiration date and define the strike price of the futures contract.
That means that if the futures contract trader holds the position until expiration, he has to buy or sell the underlying asset, regardless of what the contract by itself is worth at that time.
However, the majority of futures trading activity aims for short-term gains, and the futures contracts never get exercised since the positions are closed before expiration.
All futures trading happens on a futures trading exchange, like the CME in Chicago (Chicago Mercantile Exchange), where a broad range of futures can be traded (bonds, physical commodities, weather events, and more).
Futures Trading In a Prop Firm
Futures trading in a prop firm is a bit different than opening a brokerage account. In a prop firm, you start on a paper trading account while going through a challenge. That’s something even normal futures traders should do to practice trading. So, that’s a good thing.
The participation fee of the prop firm challenge covers all the costs, including trading platform access and real-time futures market prices. That’s also a good thing since, with a normal futures broker demo account, you’d likely have to pay the exchange fees if you want to have real-time data.
During the trading challenge, you can try various trading strategies, trade different futures contracts, and aim to reach your goal to finally get funded.
Once you are funded with real money, you’re in the same trading environment as you would be when trading with a futures broker. You access the real market with all its advantages but also disadvantages that you should be aware of.
The biggest advantage of futures trading with a prop firm is that you don’t need any brokerage account funded with your capital. That’s all done by the prop firm. And if you lose money in the funded account, you don’t have to cover those losses. At the same time, you can withdraw the profits made based on your profit split agreement.
But be aware, make sure to read the exact specifics of your evaluation and funded accounts to know about potential trade restrictions (e.g., no news trading, only specific assets tradeable) and rules (drawdown rules, etc.).
Underlying Assets Used for Futures Trading
A trader knows the exact details of future contracts before he opens a trade. He also knows what asset is behind a future contract and when it expires.
If you take stock futures as an example, then you know that the underlying asset is a stock like Apple, Amazon, Netflix, or NVidia.
There are even more underlying assets that can be behind a futures contract to trade:
- Commodity and energy futures based on natural gas, crude oil, wheat, or corn
- Interest rate futures to speculate based on underlying assets such as Treasurys and bonds
- Precious metal futures like the wonderful shining gold or silver
- Currency futures and cryptocurrency futures like the euro, US-Dollar or Bitcoin
- Stock index futures, with an underlying asset like the S&P500 or Nasdaq
- Equity futures, which are based on specific stocks
How Futures Trading Works
Futures traders trade futures contracts on an official futures exchange at a specific price for a specific asset, with a defined expiration date and expiration price.
The buyer of a futures contract is required to buy the underlying asset at the fixed strike price and expiration date if he holds the position until expiration. The buyer can also close the trade at any time before expiration if he only wants to speculate on the fluctuation of the price of the futures contract.
The seller of a futures contract is required to sell the underlying asset at a fixed price after expiration. He can also close his position before the expiration date if he wants.
It is possible to go long in a futures contract position and also to go short to speculate on falling prices. The liquidity in the futures trading markets is enormous, has great transparency, and is well overseen by regulatory authorities.
Stock Futures Trading Example
If you take stock futures trading as an example, then you have a clear structure of what you can trade, when, at what expiration dates, etc.
Let’s say you want to trade S&P 500 contracts. You then know that the S&P 500, as the underlying asset of the futures contract, holds the top 500 stocks in the United States in.
That means you speculate on the price change of this stock basket.
- You can buy the futures contract and wait a long time. In this case, you speculate about the rising prices of the S&P 500.
- You can also go short and speculate on the falling prices of the S&P 500.
Contract expiration dates are March, June, September, and December of a year, the nearest month being the so-called front month.
The most liquid futures contract is always the front-month contract because it’s used for short-term speculation.
So, if you are a short-term trader, you’ll likely choose the contract with the highest liquidity and lowest bid-ask spreads.
Pros and Cons of Futures Trading
Futures trading has its pros and cons. On the advantage side, there is clearly a high potential for profits due to the immense leverage possible when trading futures contracts with discount brokers.
The initial margin of a contract is often $500 for one E-Mini contract, which allows the trader to speculate on price fluctuations within the futures contracts with minimal capital.
This directly leads to the biggest disadvantage since the high leverage means that undercapitalized trades can quickly get stopped out of their position and can end up in a broken account. Let’s say a trader opens a futures trading account with a $500 minimum account balance. Then he loses the $500 in the first trade. Now, the account has no value, and the trader can’t trade anymore.
Pros
- High potential of speculation gains with low margin requirements
- A futures contract can be used for hedging
- High-liquid markets
Cons
- High leverage equals high risk for the trader
- Overnight margin significantly higher than the initial margin
