Investing often hinges on speculations of whether a company will succeed or fail. How profitable a company is expected to be is a major driver for investors considering buying shares.
With a pessimistic outlook, investors may consider buying put options instead of shares. Future contracts are another financial tool utilized by speculative traders who predict the price swings of asserts.
But what exactly are futures, how do they work, and what sets them apart from options? Here are the basics of trading strategies for future contracts.
What are futures?
Futures are contracts between a buyer and a seller to lock in a trade for a specific asset at a predetermined price on a future date. Buyers commit to purchasing an asset, while the seller commits to selling or delivering the asset. This could be a commodity like oil or a financial instrument like a stock index.
Futures are derivative contracts. meaning their value hinges on the performance of the underlying asset. For example, if the price of gold increases, the value of the futures contract for gold also increases. The same occurs if the price of gold falls.
Futures contracts are critical for businesses dependent on certain input goods. The airline industry, for example, is well-known for this because of the fluctuating prices for jet fuel. The use of futures contracts locks in prices and protects against unexpected costs.
The basics of future contracts
The underlying assets for futures contracts tend to be commodities like gold and oil.
Here's a short list of asset types that futures can derive their value from:
- Commodity futures: Commodities are tangible assets, agricultural products, and natural resources used in commerce and trade. A short list of futures in this category would include soybeans, corn, wheat, crude oil, and natural gas.
- Precious metal futures: Gold and silver are the most common metals in this category. Investors who purchase futures contracts on gold or silver are usually looking to hedge against global financial uncertainty, inflation, or geopolitical events.
- Stock index futures: Futures contracts can also derive value from an index like the S&P 500, Nasdaq, Russell 2000, or Dow Jones. Investors use stock index futures to capitalize on anticipated movements in an index. They can be sensitive to events like data releases, such as the U.S. jobs report or statements by the Federal Reserve.
- Currency futures: These futures contracts can be based on the exchange rates between countries. The most popular currency futures contracts include the Canadian dollar, British Pound, Japanese Yen, and Euro.
- U.S. Treasury futures: The interest rates on Treasury bonds significantly impact a large part of the financial markets. U.S. Treasury Futures allow investors to speculate on the potential changes in interest rates.
History and evolution of futures trading
Futures contracts can be traced back to the 17th century when they began as an informal arrangement between merchants and farmers to lock prices for future crop deliveries. These agreements offered both parties protection against price fluctuations. Eventually, this led to the first organized futures exchange in 1710 in Osaka, Japan, to facilitate rice trading.
Fast forward to the 19th century, the rise of agricultural hubs in the US fueled the development of formal futures markets. Cities like Chicago became centers for agricultural trade, and the Chicago Board of Trade (CBOT) emerged in 1848 to trade corn, wheat, and other grains.
Today, futures are usually electronically traded and most often used by speculative traders who want to hedge against inflation risk. Products such as energies, stock market indexes, and traditional investments are now available as futures contracts.
How futures contracts work
Futures contracts are often traded on margin but don't necessarily have to. The benefit of trading futures on margin is increased leverage and affordability. For example, an investor could spend $5,000 of their own cash to control a $100,000 investment, which represents only 5%.
Every futures contract has five key elements, also known as standard contract specifications.
- Trading hours: Futures trade almost 24 hours a day, six days a week, starting on Sunday at 6 p.m. ET. The closing time varies between 5 p.m. and 6:45 p.m. ET on Friday, depending on the type of contract you're trading.
- Contract size: Each type of contract has a predetermined size. For example, one contract of gold will always equal 1,000 troy ounces — a unit of measure used for weighing precious metals. On the other hand, one contract of S&P 500 futures will be $50 times the S&P 500 index. (So, for example, if the S&P 500 is trading at 2,300, the value of the contract would be $115,000 [$50 x 2,300]).
- Contract value: The contract value is the current price of the contract. If gold trades at $1,500 per ounce today, the contract value would be $150,000.
- Tick size: This is the smallest denomination that a contract can fluctuate and varies depending on the type of contract.
- Delivery method: Futures contracts can be financially settled or physically settled. From the investor's perspective, these are usually financially settled, whereas businesses may choose physically settled contracts.
The minimum amount of money required to enter into a futures contract is known as the initial margin requirement. Margin requirements for futures contracts fall between 3% to 12%. Depending on the price of the contract, an investor.
Uses of future contracts in finance
Hedging with future contracts
Hedging against inflation and general risk management is key to understanding why investors trade futures. Companies and individuals use futures contracts to mitigate the risk of unexpected price changes in the market while diversifying their portfolios.
"This works particularly well for anyone that needs to control input prices for a product," says Dominique Henderson, CFP and founder of DJH Capital Management.
If prices are rapidly increasing for a commodity, a futures contract can lock in current prices and help preserve profits.
Speculation and arbitrage
Investors with an appetite for speculation may see significant gains (or losses) much quicker than in other markets. Speculative investors like the flexibility for higher returns with futures trading, and the overall profit from price movements.
Short selling is the process of profiting from downward movements in the market. For stocks, short selling usually has higher margin requirements than long positions. But with futures, the margin requirement is the same for both long and short positions. This means that the investor can risk less of their cash on hand for short-selling positions with futures than with stocks.
Tax benefits
Some futures trades can qualify for preferential tax rates using the 60/40 rule (60% of the profits will receive long-term capital gains treatment, and the remaining 40% will be treated with short-term capital gains). This is a unique structure compared to short- and long-term gains with stocks.
Risks and considerations in futures trading
Understanding leverage risk
There are substantial risks involved with futures trading, especially when trading on margin vs. cash. Futures are highly volatile as prices fluctuate rapidly, leaving investors vulnerable to significant losses or gains.
You can experience an increased chance of significant loss if you don't meet margin calls. Sometimes, an investor could lose even more than the initial amount invested. If your position falls below the minimum margin requirement, you must deposit additional funds to maintain your position. If you can't maintain it, your broker may force you to liquidate at a loss.
Best practices for futures traders
Although investing with futures can be a great way to diversify your portfolio in ways that the more traditional stock and bond investment can't, the additional exposure comes with a few trade-offs. This includes higher volatility rates, longer trading hours, and special tax advantages.
"Futures tend to be a more complex or advanced financial instrument," says Henderson.
While the potential for large profits may be tempting, carefully consider the risks before entering into futures trading. It may also be wise to consult a CFP to ensure that a negative move in the futures market does not threaten your overall financial security.
Futures pros and cons
| Pros | Cons |
|
|
What are futures contracts vs. options
Futures and stock options have many similarities as both are contracts between two parties and can allow an investor to hedge and protect their portfolio. However, there are some key differences that you should be aware of.
| Futures | Options |
|
|
Futures frequently asked questions (FAQs)
How do futures contracts work?
Futures contracts are agreements between buyers and sellers to execute trades of an underlying asset by a predetermined date and time. Futures are highly volatile, risky assets often traded on margin. While trading on margin increases the probability of a higher return, it also amplifies the potential for significant loss.
Do you need a special account to trade future contracts?
You need a brokerage account to trade futures contracts. Depending on the brokerage platform or online investment app, you might have to opt in for margin trading to access futures. Before signing up for an account, make sure to check that the platform actually offers futures and that you meet the necessary requirements to access trading.
What happens if a future contract is held until expiration?
A futures contract held until expiration must be settled according to the contract terms and specifications. With futures, investors have an obligation to either sell or buy the asset by a certain date, whether this be through physical delivery of the underlying asset or via cash settlement.
Can future contracts be traded before expiration?
Futures can be traded before the expiration date, as the investors are only obligated to buy or sell by the set expiration date. Typically, traders close out their positions prior to the expiration date based on potential profit or limit losses.
How are future contracts priced?
Future contracts are priced based on the current market price of the underlying asset, called the spot price, plus the expected volatility, cost of carry, and interest rates. Futures prices can also be affected by the commodity type, such as the price for commodity futures versus futures for interest-bearing assets.
Are futures trading suitable for all investors?
Futures trading is not suitable for all investors as it involves significant risk. Only experienced investors who aren't risk-averse should consider trading futures. Moreover, futures trading isn't ideal for retirement savings or investors who prefer the buy-and-hold strategy.
