I hope you enjoyed last weeks post on Corporate Bonds. This week, we’re going to expand our discussion of alternate investment strategies to discuss futures contracts. This is an important topic to discuss because futures is one area where investors are particularly reluctant to tread, feeling that the process is “too advanced” for them, or that futures carry too high a risk.
Futures Can Be Risky
This is largely a misconception. Futures Contracts can indeed be risky, but if they are used wisely, they can also be used to guard against excessive risks! Let’s look at it this way. Suppose that you were to buy a futures contract on a stock for one year from today at $5 a share.
When the day comes, if the stock is valued under $5 a share, then you’re stuck with purchasing them and will have to suffer the loss. However, there’s also a chance that the stock could be valued at more than $5 a share, and you would have the unique opportunity to purchase it at a discount.
Minimizing this risk
In order to minimize risk on a futures contract, you need to understand the difference between hedging a risk and speculating. When you purchase a futures contract, or sell one, with the intention of minimizing a downside risk by locking in the current price on a particular commodity, then you are making a very common and wise use of the futures contract.
On the other hand, if you’re buying on the speculation that the commodity will soon soar and make you rich, then you’re taking quite a gamble. As you can see, futures can be an excellent source of investment, but it does require some thorough knowledge of the market before hand. However, if you possess that experience, you should not be unduly reluctant.
If you take the notion to purchase a futures contract, note that it can be done through most full service brokers. These same stock brokers can get you involved in futures trading, which is essentially the same concept, but applied to the trading that you’re already familiar with.
See you next week for part 7 of Investments.
Sean Rasmussen
The Bullhunters Guide
Universal Wealth Creation © 2004 – 2009
{ 4 comments… read them below or add one }
Hi Sean,
When you trade a Futures contract, are you actually trading on a stock, or are you trading on the price of a commodity and locking it in to a future date, so that when the contract expires, you either pay or pocket the difference, or can you do both under different circumstances? Trading a Put Option on a stock can also hedge the price for the future – are the two comparable?
Hi Rob
You have explained how they both work. I don’t really know if they are comparable as such. They both work with their own advantages and disadvatages.
Hi Sean,
Okay, something else I don’t fully understand. So, you can buy a stock and then a futures contract on the same stock to lock in that price? Sorry, that’s probably wrong.
I definitely wouldn’t be speculating on the price of the stock going up and then looking to cash in.
I did try trading commodities (futures) for a while but I found the market too volatile and I had to put my stops out a fair way from my buy price to allow for a wide range of movement.
I don’t have the constitution for that type of trading, as I feel it is too risky.
I need to have a strategy I enjoy doing and can be relaxed with it.