The world of trading is vast, and it can get rather complex, which is why we will help you understand it to the best of our ability. Today, we will talk about futures trading in New Zealand. We will explain what futures are, how they work, what is in futures contracts, and more.
What are futures contracts?
To start off, let's make some things clear and ensure that everyone will understand the rest of this article. So, the first thing that you should understand is what futures contracts are in the first place.
To put it quite simply, futures contracts are an agreement to purchase or sell certain assets at a future date. When you make a contract, you also agree upon the price of the asset. The asset can be pretty much anything, including some amusing products such as pork belly, orange juice, and alike. Of course, there are plenty of more 'serious' assets, such as gold, stocks, and even cryptocurrencies.
Futures contracts are traded on exchanges, and they revolve around two parties agreeing about certain terms. One party agrees to buy a certain quantity of commodities or securities, and take delivery on a specific date. The selling party, which is the party that is offering the securities or commodities, has to agree to be the first party's provider.
What makes a futures contract?
The next issue that we will tackle is what is actually inside a futures contract?
Fortunately, futures contracts are completely standardized, meaning that we know exactly what goes into each one, and there can be no surprises in that regard. Each contract specifies the number of different perimeters, including:
- The unit of measurement
- The currency in which the contracts are denominated
- The currency in which the contracts are quoted
- Whether the trade will be physical delivery of goods, or if it will be settled through cash
- Quality/grade considerations when there are any (metal purity)
Of course, deciding on these aspects depends on what you want and what you are after. However, if you are a beginner trader, we would assume that your goal is not to take physical delivery, so be sure to go with a cash option. Otherwise, you will receive a huge amount of the underlying asset when the contract expires, and it will be up to you to figure out what to do with it.
How do futures actually work?
So, now that we know what futures are and what can be found within futures contracts, let's talk about how it all fits together and how they actually work.
Basically, futures contracts allow you to choose an asset and secure a specific price for that asset. This protects you in cases where the asset is (or can become) volatile, and experience a significant price swing, which can go up or down without much of a warning.
If this is confusing to you, let's use an example to make it easier to understand.
Let's say, for example, that an airline firm wishes to buy jet fuel, but is worried that its price might go up in the next few months. The solution for the company is to get in contact with the jet fuel distributor and make a deal.
They would buy a futures contract, according to which they would buy a certain amount of fuel, at a certain time, for a certain price. This benefits the firm because it will get the asset it needs when it needs it, and for a price that it can afford. Meanwhile, it is also beneficial for the distributer, as they know that they will be able to sell a certain amount of fuel regardless of what happens with the prices, which guarantees a steady market for them.
So, the parties establish the terms of the deal, and the job is done. The terms would specify that our airline firm would buy 1 million gallons of jet fuel, which would be delivered to them in, let's say, 90 days, and at a specific price, such as $3 per gallon. Regardless of what happens to the jet fuel price during the following 3 months, both parties will honour the contract according to the terms they both agreed on in advance.
In other words, the futures market allows them to manage risks that come with price volatility. Of course, if they didn't buy/sell the contract, the price of fuel may have jumped, which would have been beneficial for the distributor — but only if they could find buyers for the fuel. On the other hand, the increase in fuel price would directly damage the airline firm's budget, potentially preventing them from purchasing all the fuel that they wanted to buy, initially (1 million gallons).
Of course, as mentioned, there is also an option to get the trade settled with cash, which is a great option for those who do not want the actual product. These people are called speculators or simply investors. Their goal is not to buy jet fuel that they could use in practice. Instead, their goal is to make money by using price changes.
Basically, if the jet fuel price jumps, the contract itself gains more value. Therefore, its owner could sell it for more money and make a profit. There are countless people who do this on a daily basis, which makes the market quite lively and brings huge liquidity to it.
Especially when you consider that not all of the underlying assets are commodities, meaning that you can use other things, and not just jet fuel and similar, physical products. It is also possible to use shares of ETFs, stocks, bonds, cryptocurrencies, and alike, as mentioned before.
These assets are usually much more volatile, which means that there is a greater potential to make a profit. Best of all, you can make that profit by using a relatively low amount of investment money, which is where things like trading with leverage come in.
Margin and leverage trading: Greater rewards with greater risk
As mentioned, people can easily invest a small amount of money and still hope for decent profits in return, which is achieved through trading with leverage.
Simply put, trading with leverage revolves around the investor borrowing a certain amount of money in order to magnify small price changes. If their speculations end up being correct, they win a lot more money than they would if they only used their original investment money.
However, the risk of losing their investment is also significantly higher, as they have less room for errors in their predictions. The market is a living being, and it moves constantly. If its movement goes against you, you can lose significantly more than what you originally invested, as well.
Leverage and margin trading are present in all spheres of the trading world, but they are typically more liberal when it comes to futures and commodities, and less so when it comes to securities. This means that commodities brokers typically allow significantly higher leverage than what a security broker would be willing to allow.
The main thing you need to remember that greater leverage comes with greater reward, but also a greater risk of loss. To use another example, let's say that the price change of only 5% could lead to you losing 50% of your investment if you leveraged 10:1. You can also gain just as much if the price changes in a way that favours your prediction.
This is a complex world of trading with leverage, and it is not for everyone. If you are a newcomer to this type of trading, it might be best to skip it for now, until you learn how the market moves and gain some valuable experience. Otherwise, you are risking your investment money on an off chance that things might go your way.
How to actually trade futures?
Finally, let's talk about how actually to start trading futures. The process is pretty simple, and all you need to do is find a broker that services citizens of New Zealand, and supports the markets you are interested in.
Once you identify the broker you are interested in, you will have to open an account with them. Be prepared for the fact that they will likely ask about your previous experiences when it comes to trading and investing, as well as net worth, income, and alike. The broker needs this information in order to determine the amount of risk that you will be allowed to take.
Basically, the broker will not let you take on too risky deals if you are completely inexperienced. This is their way of protecting you, as well as themselves, and it mostly revolves around margin and positions.
Another thing to be aware of is that futures trading doesn't exactly come with an industry-standard for fees and commission, meaning that the deal you are going to get can vary significantly from broker to broker. This is why you should research all available brokers, instead of just picking the first you come across.
Depending on the broker, you might get a different amount of advice and research, while others will just drop you into the thick of things and let you figure out things on your own. It goes without saying that new investors should seek out the first type, while the second kind is more suited for professionals who do not require assistance.
If you feel like you need practice before you actually start trading, you can even open a virtual trading account on some websites, and use the so-called 'paper money' before you start using your real funds. This is actually a pretty good way to determine your strengths and weaknesses, what knowledge you lack, and how accurate your predictions are.
Also, even after you gather some experience, you should remember to use virtual trading accounts to try out new approaches, different strategies, and alike.
Trading futures contracts is a great way to make a profit or secure the price of an asset in the future. If you are interested in trying it out, we definitely recommend doing so, although you should first do all the necessary research in order to find the best broker and figure out what you should trade.
In the meantime, you should also keep tracking new developments relevant to the markets you are interested in, in order to understand how prices change in accordance with news and changes in the real world. Other than that, the futures trading industry is yours to explore, keep learning more, and start trading with the best of them.
Author: Ali Raza - A journalist, with experience in web journalism and marketing. Ali holds a master's degree in finance and writes extensively about the financial markets and fin-tech industries.