Futures trading explained: definition & strategies

Initially created to help commodities producers mitigate risks, futures have now emerged as a standard financial product for all traders. These derivatives are leveraged, which means that trading may reward you with huge gains for a small initial investment.

In this article, we’ll introduce you to futures trading basics and the best brokers for futures trading and commodities in the UK.

What are futures contracts?

Futures are standardised forward contracts with a predetermined expiration date. Upon expiration, the buyer and seller exchange the underlying asset, which can consist of various financial instruments, at a predetermined price. The underlying asset can include stock indices, individual stocks, government bonds, or commodities such as raw materials. Additionally, there are other less common types of underlying assets, which we will delve into later when discussing the mechanics of futures trading.

The party that purchases the futures contract, thereby agreeing to buy the underlying asset at maturity, takes a long position. Conversely, the party that sells the futures contract, agreeing to sell the underlying asset to the buyer at maturity, takes a short position. It’s worth noting that futures contracts are symmetrical derivatives, as both parties are obligated to execute equal but opposite actions upon maturity.

How futures work in trading

Futures maturity dates are often set on the third Friday of a given month. So, when a trader buys a futures contract (which always has a predetermined price), they take on the obligation to buy the underlying asset at the maturity date. If a trader sells the contract, they take on the obligation to sell the underlying asset at maturity at the predetermined price.

In reality, the objective of buying a futures contract is not to hold it until maturity, but rather to profit from selling it at a higher price.

Conversely, when selling a futures contract, the goal is to close the transaction by buying it back at a lower price.

Typically, brokers do not hold the contract until maturity and notify clients to close their positions within a specified date and time. If desired, clients can then transition to trading the next maturity contract. Even if the contract were held until maturity, the settlement is done in cash. Any profits are credited to the client’s account, while losses are deducted from it.

The complexity arises when dealing with futures contracts that involve the physical delivery of the underlying asset at expiration. For instance, it could involve a specific quantity of shares, bonds, or a raw material like copper. In such cases, not only must the trader have the necessary funds to purchase the required quantity of copper, but they also incur costs associated with storing it. Conversely, the seller must possess the predetermined quantity of copper to deliver. This process can be expensive and intricate.

Most brokers provide advance notice of expiration and may close the contract prior to that date. However, it is always advisable to inquire about specific procedures to avoid any unexpected and costly surprises.

Nevertheless, it’s important to note that expiration is the exception rather than the norm. In the vast majority of cases, futures trading activities are concluded well before the contracts reach their expiration date.

When can you trade futures?

You can trade futures nearly 24/7 via your broker, although this may also depend on which service provider you choose. Generally, in the UK, the most prominent exchange for futures trading is London International Financial Futures Exchange (LIFFE), now renamed ICE Futures Europe. The trading hours depend on the specific contract.

Types of orders in the futures market

The typical types of orders used in futures trading are applicable. These include market orders, which are executed without a price limit. Additionally, there are limit orders, which specify a particular price at which one wishes to buy or sell.

Time-related orders are also commonly used. Normally, orders remain valid until the end of the trading day, but they can be set to extend for multiple days or until a specific time. The availability of such options may vary depending on the trading platform provided by your broker.

Once an order is placed, it is possible to attach stop-loss and take-profit orders to manage the strategy. These orders are designed to automatically close the position when either the stop-loss or take-profit levels are reached. This helps in limiting potential losses and securing profits.

It’s worth noting that the specific types of orders available and their functionalities may differ depending on the broker’s platform and the exchange where the futures are traded.

Costs and commissions for futures trading

When it comes to fees for buying and selling futures, they become significant for traders who engage in daily transactions, such as intraday traders. For multiday traders, the impact of commissions is comparatively lower. However, there are discount brokers (discussed below) with very low fees.

Another cost to consider is the margin. To maintain a long or short position in a futures contract, a certain amount of money must be provided as collateral.

The margin requirement typically hovers around 10% of the contract value. This amount is locked or blocked as collateral. If the position is held open for multiple days, the calculation is made daily to assess whether the position is in profit or loss.

In the case of profit, an equivalent amount is credited, while in the case of a loss, the deducted amount must be replenished to maintain the required margin level.

Once the position is closed, the broker promptly releases the margin back to the client.

It is worth noting that for intraday traders, who aim to close their positions before the end of the trading day, many brokers offer reduced margin requirements to accommodate their trading style.

Types of futures

There are 2 main categories of futures:

• Those settled in cash (cash settlement);
• Those with physical delivery (physical settlement).

In the case that the underlying is a stock index, this cannot be delivered and therefore can only be settled in cash. In the case that the underlying is a stock, a bond, or a raw material, there can be physical delivery of the underlying. Especially for raw materials, futures contracts were originally designed for physical delivery. This, however, only serves professional clients (wholesalers or raw material producers).

Since physical delivery is complicated and unnecessary for the trader, notice is always given of the remaining times for physical delivery, and a good number of brokers ask the client to close the position before the expiration. There are also futures for raw materials, and also for stocks, settled in cash, because their management is much simpler and they are preferred by traders.

Another category of futures contracts is currency futures, which are traded on the CME Group, the largest derivatives market globally. These contracts pertain to the value of major currencies against the US dollar, including significant currency crosses. Currency futures represent a specific quantity of one currency against another.

Additionally, futures contracts are available for stock indices. These futures allow traders to speculate on the performance of specific stock indices. By trading stock index futures, investors can take positions based on their outlook for the overall movement of a particular stock market index.

Currency futures and stock index futures provide opportunities for traders to diversify their portfolios and engage in various trading strategies.

Trading cryptocurrency futures: Bitcoin and Ethereum

Cryptocurrency derivatives, including futures, are not allowed in the UK for retail traders. However, if you want to trade or invest in crypto, you can do so by purchasing the real asset, as discussed in the best crypto brokers article.

Best brokers for futures trading

Here, you can find a list of the best brokers for futures trading in the UK:

Trading futures with Interactive Brokers

Interactive Brokers is one of the best choices for futures and futures options trading. The costs are lower than many other offers; for instance, for 1 E-Mini S&P 500 Future, the commission is only $0.85.

In addition, Interactive Brokers has two pricing structures for futures trading:

• Fixed rate pricing – where you pay a single flat rate per contract
• Volume-tiered pricing – where you benefit from lower costs if you plan to trade high volume.

For more information, have a look at our Interactive Brokers review.

Advantages and risks of futures trading

One of the main advantages of trading futures is the leverage effect. For instance, if a trader only needs to deposit a margin guarantee of £1,000 to control a futures contract worth £10,000, the leverage is 1 to 10.

This leverage ratio is influenced by the regulations governing the specific futures contract as well as the conditions set by the broker. Generally, more volatile markets tend to require higher margins, resulting in a lower leverage effect.

However, it’s important to recognise that the risks associated with futures trading are intertwined with its advantages. The leverage effect, while providing potential for amplified gains, can also lead to significant and rapid losses, especially in the event of sudden adverse market movements.

Example of trading strategies with futures

When it comes to trading futures, it’s essential to determine your preferred trading approach, whether it’s intraday trading or holding positions over multiple days (multi-day). This choice will influence the time frame you select for analysing price charts. Intraday traders typically focus on shorter time frames, ranging from a few minutes to one hour, while multiday traders tend to use daily or weekly charts.

Once you’ve decided on your trading time frame, it’s important to identify the technical analysis tools that align with your strategy. One common approach involves using two exponential moving averages (EMAs) of different lengths. For instance, you might choose a shorter-period EMA (such as a 20-day EMA) and a longer-period EMA (such as a 50-day EMA). These moving averages can help identify trends and potential entry or exit points based on their crossovers or interactions.

Exponential moving averages with futures

Let’s consider the DJ Eurostoxx 50 index futures and analyse a 15-minute chart with two exponential moving averages (EMAs): a 5-period EMA and a 10-period EMA.

In this example, we’ll enter a trade when the red line crosses above the green line, indicated by the upward-pointing arrow. The entry would be at the closing level of the 15-minute candle, at a price of 4,140 points.

Given that 1 point is worth £10, the contract value would be £41,140. Assuming a margin requirement of £4,000 (approximately 10%), and factoring in a commission fee of £5, we can proceed with the trade.

The exit signal would be triggered by the opposite crossing, when the red line cuts below the green line, as indicated by the downward-pointing arrow five hours after the entry. The exit would occur at the closing level, at 4,153 points and a commission fee of £5.

The total profit from this trade would be 13 points, equivalent to £130. Deducting the total commission fees of £10, the net profit would amount to £120. This represents a profit of 3% in relation to the £4,000 used as margin. The entire trade lasted approximately 5 hours.

Let’s see a short position:

In the case of a short position, we would enter the trade when the mm5 (red line) cuts below the mm10 (green line), indicated by the downward-pointing arrow. The entry would be at the closing level of the 15-minute candle, at a price of 4,051 points. Assuming a commission fee of £5 and a margin requirement of £4,000, we can proceed with the trade.

The exit signal for this short trade would occur when the mm5 crosses above the mm10, as indicated by the upward-pointing arrow. The exit would take place at the closing level of 4,041 points and a commission fee of £5.

The total profit from this short trade would be 10 points, equivalent to £100. Deducting the commission fees of £10, the net profit would be £90. This represents a profit of 2.25% in relation to the £4,000 used as margin. The entire trade lasted approximately 4 hours.

More articles & recommendations for derivative trading

• Options trading
• CFD trading
• Investing in commodities
• Dividend investing
• Index fund guide
• Where to invest in 2023?
• Stock market for beginners

Best brokers for futures trading: summary

To conclude our article on best brokers for futures trading in the UK, it’s important to note that futures trading offers several advantages and risks for traders. With the leverage effect, traders can control larger positions with a smaller margin requirement, but this can also result in significant losses during adverse market movements. Futures trading is often used for hedging, too, as it helps to mitigate risks associated with open positions. For more information, check out our article on hedging.

Trading strategies, such as using technical analysis tools like moving averages, can assist in identifying potential entry and exit points. Traders should carefully choose their trading approach, whether intraday or multiday, and consider factors such as commissions and margin requirements.

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