Trading futures is an active trading strategy. Futures have a built-in end date and a high degree of risk. They should not be considered a passive investment like stocks or bonds. They shouldn’t make up a major part of a long-term portfolio.
Instead, traders often assign only a part of their active trading account to futures. There are typically two ways individual traders use futures in a portfolio: speculation and hedging. Remember, when discussing retail trading, speculating and hedging have slightly different meanings. They differ from their meanings in the broader futures market. In the broader market, all retail traders are considered “speculators” because they’re attempting to profit from changes in prices. But when talking about managing a portfolio, speculation involves trying to capitalize on changes in the futures price. The goal is to grow a portfolio. Hedging involves using futures to reduce risk.
Futures speculators try to predict the direction of upcoming price movements of a futures contract. They can choose to take long or short positions. Let’s look at an example.
Imagine a trader is bullish on oil, thinking the price of oil will go up. They go long by buying one crude oil contract at $60. When oil increases to $65, they exit the trade by selling the contract. In this example, the trader profits from the increase in price. This demonstrates how a speculator can profit from price fluctuations.
A hedge is designed to move opposite to the portfolio it’s protecting. If the portfolio is falling in value, an appropriately placed hedge would rise. It would offset some of the losses. On the other hand, if the portfolio is rising in value, the hedge will cut into the profits. Let’s look at another example.
Imagine a trader who is long a portfolio of S&P 500® index stocks. They’re becoming increasingly concerned the market will turn bearish and cause their stocks to lose value. One choice is to sell an E-mini S&P 500 futures contract to hedge the portfolio. If the market declines, the value of the stocks will decline. But, the short futures contract should increase in value. This will offset some of the losses from the stocks. Yet, if the market goes up, the value of the stocks will rise. The short futures contract will then decrease in value. This decrease reduce the overall portfolio returns. This is particularly important to remember because short positions have an unlimited risk.
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