A futures contract is a standardized contract to buy or sell a specific asset with a fixed quantity on a future date at todayâs price. The contracts are bought and sold on a futures exchange and offers simply and strategic way of buying commodities.
However, commodity futures trading usually get bad rap. In spite of their importance to the global economy, they are among the most misunderstood of all assets. Bonds, stocks and real estate all have plenty of fans and widespread agreement amongst authorities recognize their important within a well-diversified portfolio.
Commodities are more volatile than bonds but their volatility is about equal to that of stocks. And commodities have no funky accounting, scandalous behavior by management or incomprehensible off-balance sheet items.
Future contracts are often perceived as very risky but maybe not for the right reason. Numerous traders have had their entire accounts wiped out by a trade that has gone wrong. However, trading futures does not have to be more risky than trading stocks. It is not volatility that makes futures trading risky but the extraordinary amount of leverage that is used by traders.
While 2 times leverage is allowed in the stock market 20 times leverage is common practice in futures trading. Meaning that you only need to put up 5% of the cash for a trade and borrow the remaining 95%. For example, consider that you buy a contract of gold for 100 ounces and the price is $1,000 per ounce so the underlying contract is worth $100,000. However, the actual amount of cash you have to put up to buy a single contract is only $5,000 and the other $95,000 is lent to you by your broker.
If the price of gold goes up by $50 you make a quick $5,000 and double your money. However, a drop of $50 and your broker will give you a margin call or whip out your account. A margin call is a scenario when your broker asks you to put up more capital or liquidate your trade. To avoid this situation many season futures traders recommend having many times the minimum balance in an account to avoid margin calls.
Futures contracts is one option of taking advantage of rising commodity prices. Buying a dozen ounces of gold and putting them in a safe is pretty easy and convenient but try to buy a thousand pounds of copper or a couple of thousand bushels of wheat and find a place to store it. Futures contracts can be an attractive play on rising commodity prices as long as itâs done intelligently and without too much leverage.