Futures are forward contracts: A complete guide for beginner traders

Imagine you are an airline and want to protect yourself from sudden increases in kerosene prices, or you are a soybean producer worried about a drop in crop prices. In both cases, a futures contract is a tool that allows you to lock in a price for a future date. But futures trading is not only about risk hedging. It’s also a way to profit from market fluctuations, albeit with significant risk. Let’s understand how these financial instruments work, who needs them, and how to start trading without critical mistakes.

Basics: What is a futures contract and how does it work

A futures contract is essentially a written agreement between two parties to buy or sell a specific asset at a predetermined future date and price. The asset can be anything: wheat, oil, gold, company stocks, exchange-traded funds, cryptocurrencies like Bitcoin, or even stock market indices.

The main difference between a futures contract and a regular purchase is that you do not receive the asset today. You agree on a deal that will happen later. For example, an airline might enter into a contract to buy a million gallons of jet fuel over 90 days at $3 per gallon. Both parties lock in the terms right now, regardless of what the market price will be at the delivery time.

These contracts also vary in structure: some involve physical delivery of the commodity, others are cash-settled (no actual transfer of goods). Each contract has standard parameters—units of measurement, amount, currency, and sometimes quality specifications (e.g., octane rating of gasoline).

Who participates in the futures market and why

The exchange where futures contracts are traded gathers three categories of participants. The first are hedgers: actual producers or consumers of goods who need to work with the underlying asset. An airline buys futures contracts for kerosene because it genuinely needs fuel. A grain producer sells futures to hedge against a fall in crop prices. The futures market helps them manage price risks.

The second category includes investors and speculators. They generally do not want to receive 1000 tons of corn or a trainload of pigs. Their interest is in the contract itself. If the price of aviation fuel rises, the contract becomes more valuable, and they can sell it for a profit on the market. These participants add liquidity, enabling the market to function more efficiently.

According to data from the Commodity Futures Trading Commission (CFTC), most futures market participants are commercial and institutional producers of goods. All transactions must go through exchanges and firms registered with the CFTC. This creates a certain level of standardization and oversight.

Futures as a way to leverage

One reason futures are popular among traders is the ability to work with high leverage. If in the stock market you can leverage roughly 2:1, in the futures world brokers offer 10:1, 20:1, or even more, depending on the contract.

What does this mean in practice? Investing $10,000, you can open a position worth $100,000. This amplifies potential gains but also increases risk. If the price moves just 5% in your favor, you could earn 50% return on your invested capital (with 10:1 leverage). But if the price moves against you by 5%, you could lose half of your money.

The CFTC openly warns: futures are complex and volatile instruments, not recommended for ordinary investors. Margin rules (collateral requirements) are much more liberal than in the stock market precisely because the risks are higher.

Trading strategies: from hedging to speculation

Position hedging. An investor holding a stock portfolio may fear a market decline. They can sell a futures contract on the S&P 500 index without coverage (short position). If stocks fall, they profit from this position, offsetting losses in their main portfolio.

Long positions for growth. Conversely, if an investor is optimistic and believes the market will rise, they can buy a long contract on the S&P 500 to boost potential gains from growth.

Speculation on price differences. A trader can analyze charts and trade short-term price movements without any physical asset involvement. This is pure speculation on volatility.

Futures contracts are not only for commodities—coffee, soybeans, oil. You can trade futures on individual company stocks, ETFs, bonds, and even cryptocurrencies. This makes the futures market a versatile tool for various strategies.

Risks and pitfalls: margin and volatility

Many traders borrow significant amounts to play in futures markets because this allows turning small price movements into substantial profits. But it also doubles the risk. If the market moves more sharply than expected, you can lose everything you invested and even end up owing money.

Volatility here is higher than in the stock market. Speculators need strict discipline to avoid taking on excessive risk. Margin (the collateral you must maintain in your account) can be recalculated daily. If your position moves against you, your broker may require additional funds. If you cannot provide them, you may be forced out of your position with losses.

Additionally, there is a risk of physical delivery. Most casual traders do not want to receive a container of pigs or a train car of raw materials. It’s crucial to monitor the expiration date and close your position before expiry if you do not plan to take actual delivery.

How to start trading: a step-by-step plan for beginners

Step 1: choose a broker. Open an account with a futures broker that provides access to the markets you want to trade. The broker will ask about your investing experience, income, and capital. These questions are necessary to determine the maximum margin and position sizes you are allowed to open.

Step 2: study the fee structure. There is no single industry standard for commissions and fees. Each broker offers different services. Some provide in-depth analysis and advice, others just show quotes and charts. Compare offers before choosing.

Step 3: practice on a virtual account. Most brokers offer a paper trading account where you trade with virtual money. This is invaluable for beginners. You can test your understanding, see how margin and commissions affect results, and refine your strategy without risking real money.

Step 4: start small. Even when moving to a real account, begin with one contract. While experienced investors test new strategies on paper, beginners are strongly advised to do so as well.

Futures are a powerful tool, but without proper preparation and discipline, they can lead to serious losses. Spend time learning, practicing on a virtual account, and only then move on to real trading with money.