Futures contracts are a type of financial derivative that investors use to speculate on the price of a security at a forthcoming date. These typically trade on separate futures exchanges, which allow for higher volumes of trading.
Futures are a type of derivative, and trading futures and other options contracts requires an advanced level of trading and market knowledge. That said, investors would do well to know the basics of futures contracts, so that they can determine whether they have a place in their investing strategy.
What Is a Futures Contract?
Futures contracts, or futures, are legal agreements to either buy or sell a given security, commodity, or asset at a specific time in the future, for a previously agreed-upon price. For investors, they offer access to commodities and other markets they might not be able to access otherwise. They can also act as a way to protect against volatility.
One important feature of a future contract is that both buyers and sellers can execute the contract regardless of the current market price of the underlying asset when the contract expires.
Investors use futures contracts when they believe that the underlying security will go up or down by a certain amount of time over a fixed period of time. The futures contract buyer enters a legal agreement to buy the underlying asset at the contract’s expiration date. On the other side of the trade, the futures contract seller agrees to deliver the underlying security at the agreed-upon price, when the contract expires.
The majority of futures contracts on a futures exchange are standardized by date and price, to allow for higher trading volumes and simpler transactions.
Investors can buy futures contracts to make money — or to hedge against losses — resulting from the price increases or decreases in stocks and commodities like oil, as well as other financial instruments.
💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.
How Do Futures Contracts Work?
In a futures contract, the purchaser gets to buy a given asset at a predetermined price. That can help protect against big price swings up or down, making them popular not only with investors, but with companies that rely on commodities that experience sudden price changes.
Example of a Futures Contract
An airline, for example, might buy an oil futures contract to lock in the price of the oil that it will need to buy in order to get its jets off the ground in the coming months. Purchasing the futures contract allows the airline to guard against the financial harm of a sudden rise in the price of fuel. The risk to the airline, however, is that oil prices will go down – in which case, it will miss out on those lower prices.
On the other side of this hypothetical transaction is a fuel distributor, which has millions of gallons of oil in its inventory. It would sell the oil futures contract as a way of maintaining a steady market for its oil in the coming months. That’s because the airline buying the futures contract must buy the fuel at the agreed-upon price on the dates specified in the contract. That removes some risk for the oil distributor, but it also creates a risk if oil prices climb before the futures contract expires. Should that happen, the oil distributor will still have to sell the oil at the lower price specified in the futures contract.
To stay with this example, in the futures contract, the airline and the oil distributor will set and agree upon the terms, specifically the price of the oil and the expiration date upon which the contract expires. In this contract, the distributor agrees to sell 1,000 barrels of oil at $50 per barrel, in exactly 90 days. If the price of oil in 90 days is $75 per barrel, then the airline will have gotten a good deal. If a barrel of oil falls to $35, then the oil supplier will have protected itself against the price declines.
What’s the Difference Between Futures and Options?
Futures and options are both derivative contracts. However, futures contracts oblige the buyer or seller to complete the deal at the contract’s expiration, while options contracts give traders the right but not always the obligation to execute the contract when it expires.
Recommended: 10 Important Options Trading Strategies
Both futures and options share some of the same trading terminology. For example, both investors in both types of derivatives will need to consider its bid-ask price. The bid price is the highest price a buyer will pay for the contract, while the ask price is what the seller will accept.
Investors can also purchase options on future contracts. In a call option on a future, the buyer has the right to buy a futures contract at a specific price at a specific future date. In a put option, the buyer has the right to sell the futures contract at a specific price at a specific date.
Futures Contracts Pros & Cons
Futures trading can be a profitable strategy, but it also has some drawbacks that investors should consider.
Benefits of Futures Contracts
• Futures contracts act as a hedge against the risks related to price volatility.
• Most futures markets are highly liquid, allowing traders to buy and sell when they want.
• Futures may give investors access to commodities, and other markets not normally accessible to everyday investors.
• Futures contract pricing is determined by adding the cost of carrying the underlying asset to its spot price.
Downsides of Futures Contracts
• Futures contracts can be a high risk investment. In some cases, a futures contract can lose all of its value and trade at $0 when it expires.
• Futures contracts can reduce or eliminate potential gains from price swings in the underlying securities or assets.
• Futures contracts themselves are often highly volatile, with their prices fluctuating wildly.
• You may have to pay high commission charges on high-volume trades.
How Investors Use Futures Contracts
But not everyone who buys an oil futures contract plans to take delivery of the oil it represents. Retail investors also use futures as a way to protect their investments against volatility. Those futures investors who buy and sell the contracts to make money off the price changes that the contracts themselves undergo.
To go back to the example of an oil futures contract, an investor owns a contract, and the price of oil rises, allowing the contract owner to buy oil for less than the market price. The investor will be able to sell that contract for more than they purchased it for. The investor will then sell the contract on the futures market.
Other investors use futures contracts related to other commodities, including corn, soybeans and wheat. But there are also futures markets where investors can buy futures contracts that offer them the ability to bet on the future of currencies, individual stocks or stock indices like the S&P 500 or 10-year Treasury bills. Investors may choose to buy futures, rather than the securities themselves, to reduce their volatility exposure.
How to Trade Futures Contracts
There are several steps to trading futures contracts.
1. Open a brokerage account
To trade futures contracts, the first thing you’ll need is a brokerage account. You may also need your broker to give approval for margin and options privileges in your account.
2. Set a trading strategy
Before jumping into the futures market, develop a strategy. That strategy could involve technical analysis based on market data, or fundamental analysis based on the investment’s underlying economic and financial trends.
Some investors even try out their strategy using hypothetical trades before they start trading with real money. This allows you to understand the risks of potential trades without actually losing money.
3. Research trades that make sense for your investment strategy
Most brokerages that offer futures trading have an online platform you can use to research specific securities and see futures contracts available to buy or sell.
4. Double-check the terms
Make sure that the contracts will do what you think. That means confirming the selling and purchase price of the contract, the expiration, and the fees.
5. Develop your skills
Whether doing it on paper, or with real money, you’ll want to refine your strategy over time. You may find that you make more profitable trades in a specific sector, for example, or need to work on staying calm as security prices rise and fall. Practice will allow you to improve, and get more out of the futures strategy you’ve developed.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
The Takeaway
Futures contracts are a type of investment that can offer access to commodities markets, as well as a way to protect against volatility. They can be a helpful tool to some investors, but they’re also risky and can be an expensive way to invest.
Futures trading can be fun and profitable, but is incredibly risky. It’s also a high-level trading strategy, and one that may not be suited for beginning investors. If you’re curious about it, though, you may want to speak with a financial professional for guidance.
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