Avoid futures shock by doing homework before investing

Every American has the God-given right to lose money in the financial markets, and one of the fastest ways to do it is trading futures contracts.

Whether it's oil, Treasury bonds, foreign currencies or stock indexes, if you're speculating on asset price movements with futures contracts, you can lose a lot of money very quickly.

"Don't come into the market slinging futures contracts," said Anthony Crudele, head of online future trader community Beacon Trader. "It's just not smart.

"People have to educate themselves before they start using them," he added.

Crudele is an unabashed fan of futures contracts as a means of hedging existing risks and speculating on future price movements of a wide range of assets. 

While futures markets are and always will be dominated by large banks, corporations and institutions — most of them looking to hedge risk exposures in the most liquid markets in the world — interest in futures among the retail investor community is also growing.

"The professionals will always trade in these markets, but I see a resurgence of interest among small retail investors, as well," Crudele said.

The two most popular markets for small investors are the S&P 500 E-mini contract, based on the S&P 500 Index, and the crude oil contract, both of which are hosted by the CME Group, the largest derivatives and futures exchange in the world.

"We've seen tremendous growth in our equity index and energy products during the past few years," said Mark Omens, executive director and head of retail sales at the CME Group. "It's been driven by ongoing volatility in crude oil markets, as well broader economic and geopolitical uncertainty.

"More and more individual investors are turning to futures to help manage that uncertainty and volatility," he added.

The growing demand from retail investors is, in part, being spurred by the increasingly sophisticated educational and trading resources now available to them. The big online brokerages, such as Schwab, TD Ameritrade and E*Trade, have all invested in derivatives platforms that include futures trading, and new firms like Quantcha and Quantopian are enabling small investors to write their own trading algorithms. 

"There's been an explosion in the number of advanced automated trading tools available to retail investors," said Will Acworth, senior vice president of data and research at the Futures Industry Association.

That doesn't mean that you should use them and dive into the futures markets. Futures contracts are highly leveraged and typically require a margin of between 5 percent and 10 percent up front to open a position. The market is settled on a daily basis, meaning if the market moves against an investor, they will have to top up their margins to maintain the position. The losses can accumulate quickly. 

"Futures are probably better for more sophisticated investors," said Kevin Fischer, an options trader with Interactive Brokers, one of the largest derivatives brokerages in the country. "We get calls all the time from people with open positions asking for information they should have known before taking the position."

The key difference between options and futures contracts is that the first grants the buyer the right to buy or sell an asset for a specified period of time, while the second creates an obligation to buy or sell the asset at a future date. With options, buyers' downside risk is limited to the premium paid for the option. If the market moves against them, they can either sell their option in the market for a loss or ultimately let it expire without exercising it.

With futures, however, the potential downside risk is much greater. If an investor agrees to buy oil for delivery in three months at a price of $50, they could lose the entire value of the contract in the unlikely event of oil becoming worthless. If that investor put up a 10 percent margin on the contract, he or she would have to increase the margin amount on a daily basis when the market moves against them while they receive credit to their account when the market moves in their favor.

For investors looking to actively trade in asset markets on a 24-hour basis, futures markets offer the most liquid and diverse platform for doing so. "The futures market is the easiest place to come, open an account and trade your ideas on a global basis," said Crudele of Beacon Trader.

If an investor's objective is simply to hedge a portfolio of stocks, however, options may be the simpler and better solution. For one thing, you can trade them through your regular securities account, as opposed to finding a futures commission merchant (FCM) to handle any trading in futures contracts.

"I think the option is the better hedge," said Fischer at Interactive Brokers. In markets with low volatility, option premiums shrink, reducing the cost to hedge an existing portfolio. In more volatile markets, optionality becomes much more expensive and valuable. In the futures market, investors simply pay the commission on the transaction.

Either way, investors have to beware with futures.

The market regulator, the U.S. Commodity Futures Trading Commission, maintains a database on FCMs and brokers at smartcheck.cftc.gov that lets investors check the backgrounds of firms and individuals, as well as the latest fraud schemes in the market.

Fischer also suggests that novices take advantage of all the educational material at exchanges such as the CME Group (at myfuturesinstitute.com), and practice paper-trading in the markets to get a feel for trading before committing actual money.

"There are good ways and bad ways to use all financial products," Fischer said. "It's about educating yourself and understanding the pros and cons of them."

— By Andrew Osterland, special to CNBC.com