Futures belong to a class of financial products called derivatives. Their price is derived from another asset, such as stocks, bonds or commodities like coffee and orange juice. To master futures trading, you must understand not only the mechanics of futures but also the price movements of the underlying asset.
Understand the Futures Market
A futures contract is a binding agreement to buy or sell a specific quantity of an asset at a predetermined price and date. For example, such a contract might specify that you will buy 1,000 shares of Microsoft at $20 each on Feb. 1. In most cases, it is not necessary to physically purchase the asset and arrange shipment. Instead, you can "mark the transaction to market," which means paying or receiving an amount of cash that represents the difference between the asset's contractual exchange value and the prevailing market price.
If the market price of Microsoft shares on Feb. 1 is $24, the futures contract represents a profit of $4 per share for you, the buyer, since you can buy each share at $20 and immediately sell them at $24. You can settle this contract by receiving $4,000 in cash from the seller. It is especially practical to settle in this fashion if the asset is a commodity like orange juice that is hard to transport or to store.
Study the Underlying Asset
Once you understand the contractual liabilities of futures, and settlements, pick a few assets that futures are commonly traded on and study their price movements. If you wish to specialize in stock futures, pick a handful of stocks and focus on them. If you will trade commodity futures, study the supply-and-demand dynamics, seasonal price patterns, and legislation that influence the price of that commodity. As a coffee futures traders, you must know the major buyers and sellers of coffee beans and how weather patterns affect the coffee crop. You must also understand the relationship between oil prices and the resulting shipping cost of coffee.
Cut Your Losses
Perhaps the single biggest mistake in trading is to let an initially manageable loss mount until it becomes devastating. Traders do this because none of us likes to admit a mistake. If we stick with a losing position, there is always a chance that the market will turn around, or so we hope. A far more prudent way of trading is to set a "stop loss," the point at which you will terminate the trade. This allows you to keep losses under control, exit a losing trade, regroup and try again the next time. For example, if you have set aside $20,000 to trade Microsoft futures, the stock price that represents a $1,000 loss in any trade might be your stop loss, meaning you will end the trade when you lose $1,000.
Short-term trends in the financial markets and the tone of financial news can be highly volatile. Traders who let price action and news determine their outlook quickly get lost. However, successful traders are not afraid to make a prediction and stick to it until big events or the price action proves them wrong. When you trade Microsoft futures and believe the next earnings announcement will be highly positive, stick to your guns until the announcement or until the price hits your stop loss and forces you out. Do not reverse your position just because you read an article predicting a bad earnings announcement.
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