What Are Futures and How Do They Work?

Futures are also known as stock futures and futures contracts. These are complex agreements that involve fast-moving trades across a variety of markets. 

In a nutshell, these are financial contracts to buy commodities or stocks at a certain price on a set date in the future.

Futures are legally binding, and the parties involved must buy or sell financial instruments at an agreed price on a predetermined date. The price remains the same irrespective of the swings in market value.

Futures trading is possible with many different types of assets, including stocks, commodities, and currencies. In this article, we focus on stock futures investing. 

How Futures Work

Investing in futures enables investors to set a specific price and date, which can offer protection and reduce risks. The agreement between buyers and sellers has an expiry date, and the price is predetermined.

The buyer is obliged to take the asset at the agreed price on the date specified, but they can sell their position before the expiry date. 

When you invest in futures, you can benefit from the leverage. That’s because you are only required to put up a certain percentage of the value of the trade (a margin) when you enter into a futures contract. 

The broker will request a portion of the contract value, and they will determine the margin. The amount the broker asks for will depend on the value of the contract, the investor’s credit history and rating, and the individual terms and conditions set out by the broker. 

Most traders who engage in futures speculate on the direction of the price of the asset. These contracts are closed and involve a cash settlement.  

Futures belong to a class of securities known as derivatives because they derive their value from the value of the asset in question. In that sense, futures are the same as options. But these two terms are markedly different in many other respects. 

With options, the buyer isn’t legally obligated to exercise the buy or sell clause. With futures, on the other hand, this isn’t a right, it’s an obligation, and both parties must fulfill the terms of the agreement. 

How Are Futures Used?

There are two primary uses for futures:

Hedging

Hedging is most commonly used for investing in commodities. Investors use futures to hedge price movements on assets as a means of reducing the risk of losses.

Most companies that hedge either produce or use the asset in question. An example is a farmer that produces corn. Farmers can use futures to lock in the price of their products, shielding them against price movements. 

Speculating

Futures provide investors with the option to speculate on the direction of the price of commodities, currencies, and stocks. Investors can earn or lose money based on changes in the price set out in the futures agreement and the trading price.

Futures enable investors to make money faster than traditional trading. 

Here is an example: An investor wants to invest $1,500 in Company A. They can either buy 10 stocks at a cost of $150 each or a futures contract, which covers 100 stocks at a margin of 10%.

If the share price for Company A increases by $10, investors stand to earn $100 if they bought stocks, but they would earn $1,000 if they invested through the futures contract. 

A Closer Look At Futures Contracts

Futures contracts are widely available on commodities exchanges. They are standardized and contain detailed information about the agreement. A typical futures contract contains the following information:

• The unit of measurement
• How the trade will be settled: either through cash or the delivery of physical goods or products
• The quantity of goods
• The currency being used

The Pros and Cons

There are many advantages for investors, but there are also downsides and pitfalls to be mindful of. Here are some pros and cons to consider:

Pros

• Opportunity to speculate on prices: Futures trading offers investors the opportunity to speculate on the direction of the price of assets. This means that investors can still make money if assets lose value over time, provided their forecasts are accurate.
• Protection for companies: Companies often use futures to protect against losses on assets and commodities they produce or use. By using futures, businesses can hedge prices to protect against negative movements.
• Trade without putting down huge sums of money: One of the reasons why futures are popular is the option to trade without having to invest huge sums of money. Futures usually enable you to put down a deposit or a certain percentage of the value of the trade rather than the entire contract value.
• Liquidity: Futures markets are fluid, and this means that investors can take advantage of liquidity to adjust their positions without paying costly transaction fees.
• Diversification: Futures provide access to new opportunities for investors. With futures, investors can access a wider range of assets than with stocks and ETFs.

Cons

• Risk of losses: The risk of losses is relatively high with futures because the assets are heavily leveraged.
• Hedging can cause businesses and organizations to lose out on profits if the price goes up in the interim.
• The use of margins can be a double-edged sword. Profits can be higher, but so can losses.

How to Start Trading Futures

To trade, you will need to open an account with a reputable brokerage that offers access to the markets in which you wish to trade.

Some brokers ask questions about your experience and then offer advice and tips. Others will simply present you with a chart and a quote once you have provided information about your history and trading experience. If you are offered the chance to set up a paper account, don’t hesitate.

This is essentially a demo, which enables you to get to grips with futures and learn how they work before risking any capital. 

If you select a futures contract, your broker will set out the margin. If the contract is worth $150,000, for example, and your broker sets the margin at 10%, you will need to pay $15,000. 

Closing Thoughts

Futures offer an array of advantages for investors, but they may not be the best option for everyone. They are not recommended for traders who don’t have much experience. Futures can be risky, even for experienced investors, and traders will often test new strategies using paper accounts even if they have a long history of trading futures.

Futures are often beneficial to investors who are looking to diversify and take advantage of highly leveraged investments and low commission and transaction fees.

Those who like to speculate can also make money much faster through futures than through conventional stock trading.