If you ever watch the financial news before the stock market opens for the day’s trading, you may hear about movements in the “stock futures.” One of the main reasons that futures prices are discussed before the stock market opens is that they indicate how the stock market may begin trading.
For example, if futures on the S&P 500 index are trading down significantly before the market opens, it usually means that the market will fall by a sizable amount right after it opens, with the opposite also being true. But what exactly are “stock futures,” how do they trade and how are they used? Read on to learn the basics of this exciting but potentially risky investment.
What Are Stock Futures?
Stock futures are derivatives contracts. This means their value is based on — or “derived” from — the prices of other assets. This makes them somewhat similar to options contracts.
However, there is one very important distinction between options and futures. Options give investors the right to buy or sell a specific asset at a specified price before a certain date. Futures, on the other hand, require investors to buy or sell that asset according to the terms of the contract.
How Do Stock Futures Work?
If you’re buying futures on a tangible asset, such as corn, you can actually receive a physical delivery of corn on expiration date. However, since stocks are intangible assets, there is only a cash settlement on expiration date.
Futures are “marked-to-market” on a daily basis in your account. In other words, if your position moves in your favor, your account value is automatically credited. If you own stock futures and the market falls, your account is automatically debited.
How Are Stock Futures Used?
Stock futures can be used in a variety of ways. However, there are two fundamental strategies that underlie the buying and selling of most futures: speculating and hedging.
While hedging was the original intention behind futures in general, when it comes to stock futures, their primary use is for speculation. This is because futures are both liquid and offer leverage.
If you believe that the S&P 500 index is going to rise in price, for example, you can buy futures on that index for a fraction of the price that it would cost you to buy an ETF or mutual fund that tracked that index. Futures are also available for trading nearly 24 hours a day, unlike ETFs and mutual funds, which are only available to buy or sell when the stock market is open.
This combination of factors makes futures the preferred choice of traders who feel strongly about upcoming movements in the stock market.
Traders can also use futures to hedge their own positions in the stock market.
Imagine you own a sizable position in the S&P 500 index via ETFs or mutual funds. Even if you feel the market is going to fall, there are many reasons why you may not want to sell your stock position, from tax reasons to transaction costs.
In this scenario, you can sell S&P 500 futures so that if the stock market does fall, the value of your futures contract will increase, matching or even exceeding the loss on your original ETF or mutual fund position. This is one way to manage risk within a portfolio at a relatively low cost.
What Is the Risk/Reward Profile of Stock Futures?
Futures can be risky because they are highly leveraged. Depending on the type of futures contract you are trading, you’ll usually only have to put up between 3% and 10% of its value to buy it. This type of leverage magnifies both gains and losses.
An absolutely critical thing to understand about futures is that, unlike with options, you can actually lose more money than you put in when you are buying futures. As your account is marked to market every day — and your investment is highly leveraged — if your position moves against you, you’ll have to continue adding money to your account in order to remain within the margin parameters of the contract.
If you fail to answer this request for money — known as a margin call — your brokerage firm may liquidate your position, and you’ll still be on the hook for the additional money you owe.
On the other hand, futures also offer investors a great way to leverage their bets on stock indices without having to put up a large sum of money upfront. If the stock market rallies strongly while you hold a futures contract, you could make multiples of the money you initially invested.
What Are Other Types of Futures?
The original intention of futures markets was to reduce the risk of farmers and wholesalers. Farmers would receive cash up front for the value of the crop they had yet to harvest, and wholesalers received a guarantee that product would be delivered to them at a certain date. Both parties agreed to terms before the transaction actually occurred, accepting the risk that they could have gotten better terms in the future.
While this is no longer the primary use of futures, contracts like these are still traded every day, across a variety of tangible and financial products. Here’s a list of just some of the types of futures contracts you can still buy or sell:
- Currency futures on everything from the Mexican peso to the New Zealand dollar
- Energy futures on products such as crude oil and natural gas
- Livestock futures on things like cattle and hogs
- Metal futures on copper, silver, gold and others
- Grain futures on crops like wheat and soybeans
- Food contracts on agricultural products like sugar, orange juice and coffee
While most of these futures contracts are used for hedging and speculation, some investors still do take actual delivery of the tangible products underlying non-financial futures.
The Bottom Line
Certain types of futures are now available even from online brokers, making their trading seem easy and effortless. However, it’s important to understand the ins and outs of how they operate — and the risks you’ll be exposed to — before you begin trading.
You should strongly consider speaking with a financial advisor about whether or not stock futures are appropriate for you and if they’re a match for your investment objectives and risk tolerance.