Those who spend enough time trading and reading about stocks will inevitably encounter futures. Put simply, futures are contractual agreements where two parties agree to buy or sell a fixed amount of an asset at a given price. These often involve stocks, but can also deal in commodities such as gold or pork bellies. Movie buffs also might recall the 1983 film “Trading Places” where the revenge plot involved a conspiracy to corner the futures market in frozen concentrated orange juice.
Traders, however, should not expect futures to work quite as they did in that film. Electronic exchanges have replaced the trading floors that once defined the exchanges. However, they still attract the interest of investors and speculators and trade on exchanges. By understanding futures, you can attain a better understanding of investment options and evaluate whether they fit your investment needs.
Here’s a look at what you’ll find as you read about stock market futures:
- What Are Futures?
- What Is the Futures Market?
- What Are the Risks?
- Futures Vs. Options
- How To Trade Futures
- Should I Invest in Futures?
In a futures contract, a party agrees to buy or sell a specified amount of a particular asset — at an agreed-upon price on a specific future date.
The asset often involves a financial instrument such as a stock or bond, but it can also pertain to grains, metals, foods or foreign currencies. The Securities and Exchange Commission does not regulate futures. Instead, the Commodities Futures Trading Commission handles that job.
The CFTC mandates that most futures trades occur on a trading floor of a commodity. Moreover, they require individuals who trade futures or give advice on these securities to register with the National Futures Association.
In a futures agreement, one party agrees to buy a specific quantity of an asset at an agreed-upon price on a certain date. Conversely, a seller agrees to sell that asset subject to the terms of the contract.
Mathematical models usually determine the cost at which a contract sells. The spot price, risk-free rate of return, length of the contract, dividends, and, if applicable, storage costs all go into the determination of a contract’s price.
Such contracts are standardized. A futures contract involving a stock is always 100 shares. An agreement involving oil constitutes 1,000 barrels.
Investors buy futures contracts for a variety of reasons. Many have every intention of selling before the contract expiration date and merely want to bet on a stock or commodity price. Others may own the security. They may fear that the price will fall, and buy the right to sell their stock at a specific price for an extended length of time. Other buyers have every intention of taking delivery. For example, an airline that wants to guarantee a particular quantity of jet fuel will be available at a given price.
The average consumer will likely not participate in the futures market. Moreover, investing in such securities involves exponentially higher risks than an individual stock. For this reason, futures are best-suited for seasoned investors.
Futures contract specify an asset. They spell out the price of the commodity that will be bought and sold as well as the specific date. Quantities are fixed in a futures contract. All of these factors determine the price of the contract itself. The value of the contract will rise or fall based on changing market conditions, however.
Like with all financial instruments, futures trading offers both advantages and disadvantages. Futures can bring gains, but they also bring with them risk levels not appropriate for the average investor.
Here’s a look at the pros and cons of futures trading:
|Pros and Cons of Futures Trading|
|Can speculate on price direction||Losses can exceed initial investment|
|Can help traders preserve gains||Can miss out on unpredicted gains|
|Allows control of an asset at a fraction of the cost||Leverage amplifies gains/losses|
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Due to CFTC regulations, futures trading must take place on a trading floor. A trading floor is a facility or area where traders make bids and offers. Facilities can either be physical or electronic. In either case, traders can process multiple bids and offers and, if desired, choose to accept them through executed contracts, agreements or transactions.
In past decades, this occurred in an “open outcry” system where such agreements were physically bid upon in a trading pit. During the 21st century, a specialist system — one where such auctions occur electronically — replaced this system.
As mentioned before, futures generally carry much higher risks than individual stocks. The risk is such that the CFTC describes stock market futures as “rarely suitable” for individual investors. Individuals can’t only lose all of their initial investments, but they may also have to pay more than the initial investment in certain instances.
Investors must also deposit an amount of money with their broker called a margin. The amount deposited when they initiate a trade is called the initial margin. Traders must also have on deposit a maintenance margin at all times — aka money that the broker can claim should a futures trade lose money. If the investment falls at or below the maintenance margin, the broker makes a margin call and closes the trade.
For example, you believe the price of widgets will fall, so you agree to sell 1000 widgets you do not possess at $1,000. Guessing wrongly could bring you substantial costs. If that price rises by 50% over the length of the contract, you would have to spend $1,500 — $1000 + $500 cash held in a margin account — to buy the 1000 widgets.
Traders often turn to futures since they offer leverage, which allows traders to control large dollar amounts of an asset with a relatively small capital allocation. In addition, it increases the profit and loss potential significantly. Modest gains could massively increase the value of a futures contract. A relatively small decline in the underlying asset, however, can lead to significant losses or even wipe out an investment.
Hence, futures investors should assess their tolerance for risk, as well as what they can afford to lose, over and above an initial investment. Investors should also understand contracts thoroughly and read all risk-disclosure statements carefully. Also, you should know where to go with any questions and conduct in-depth research before opening a futures trading account.
Futures and options carry similarities. However, the key differences involve what is sold and the degree of obligation.
A futures contract usually involves a commodity. In a contract, one agrees to buy or sell a fixed amount of the commodity, taking delivery at a future date for an agreed-upon price. Both sides hold a legal obligation to fulfill the terms of the contract. Offsets, or selling an equal number of contracts to compensate for the obligation, could also fulfill terms of the contract.
Options may involve commodities, but can also involve different asset types. As the name implies, buyers purchase an option, meaning they can choose not to fulfill the terms of the contract.
An option will either be a call or a put. Call options grant the buyer the right to purchase a fixed amount of an asset or commodity at a specific price at any time until the agreed-upon expiration date. Put options work in the same manner, except that puts give you the right to sell an asset or commodity under the same conditions.
Thanks to electronic trading, investors can easily learn how to trade futures. You simply need to open a brokerage account with a broker that supports the markets where you want to trade.
Investors have numerous choices when choosing a futures broker. Many brokerage sites will try to draw you with research tools, tools with which to conduct practice trades, customer service offerings or low commissions.
Like with buying stocks, some platforms will simply facilitate the desired transactions. Others can include broker services that can advise clients. These will typically come with a higher fee. Given the difficulty of trading futures for some, however, the broker advice could be worth the cost.
Traders buy or sell futures contracts for a variety of reasons. Should you buy such a contract, the best reasons usually involve risk management.
For example, if you owned 500 shares of Microsoft at $150 per share but are worried the price will fall, you could buy a futures contract called a put option with a strike price, or exercise price, at $150 per share. Since each option represents 100 shares, you would need to purchase five options to protect that position.
If the price of MSFT fell to $100 during the time the options remain in effect, you have two choices. You can sell the options at a profit, taking the capital gain on the sale. You may also perform an option exercise. This move would sell the shares, except the transaction would occur at $150 per share instead of the $100 price.
Should the price of MSFT rise during that time, the option would become worthless and expire. In such a case, you would only lose the amount you paid for the options.
Buying futures resembles the process of buying a stock but includes extra steps. If purchasing an option on a stock, traders go to an option chain. This gives a list of possible strike prices of an option and the price of the option itself based on a specified expiration date. Investors usually can buy at the ask price or specify the desired limit price.
Once they choose the option, they select their action as “buy to open,” which signals they want to purchase the contract. Buyers are also asked to specify the number of contracts, desired price, type of order (limit or market), and the expiration for that option. Assuming a seller agrees to the desired conditions, the buy will go through.
Selling futures works much the same way as buying. When prompted to specify an action, however, an investor would select “sell to close.” Also, while investors pay the “ask” price while buying, they will have to sell at the lower “bid” price. Similar to the buying process, however, you specify the number of contracts and specify a limit price if desired, hoping to find a prospective buyer.
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As stated previously, futures investing rarely fits the needs or risk profiles of individual investors. But understanding what futures are and how they work widens investment knowledge and informs of possible investment courses of action. Moreover, the futures market increases options for institutional investors and can provide a critical tool in risk management. Even so, investing in futures carries with it high risks — including the loss of more than just an initial investment.
Should you think you can benefit from investing in futures, consult a trusted advisor for further guidance. For most individual investors, however, the power of futures will come from knowing how they work instead of putting investment dollars into such instruments.