Futures, short for “future contracts,” are legally binding agreements to buy or sell a stipulated quantity of stock, commodity, or security at a specific price in the future. The future date is set, and the agreement must be fulfilled through cash settlement during the physical delivery.
The futures market started in the commodities industry with oil and gas producers, farmers, and other businesses. They produced commodities and wanted a way to mitigate the risk of having to accept an unknown price for their future production. Future contracts were the solution.
How Future Contracts Work
Futures allow one party to set a specific price for their stock, security, or commodity without the risk of wild price swings – up or down. The other party agrees to buy the provided quantity and take delivery on the date outlined in the contract.
Individuals and corporations tend to use futures to manage risk. For example, when a farmer wants to sell their crop to a bakery and the price of wheat falls between now and the harvest, without a futures contract the farmer would take a loss. However, with this contract, the farmer can have predictable compensation for their crop and not worry about the loss of income.
But, futures go beyond commodities. Future contracts can be based on non-physical assets like stock market indexes or long-term resources like foreign currencies or Treasury bonds. In short, these types of contracts allow you to lock in the future expectations, regardless of the valued end outcome.
Speculation
Speculation in its simplest terms is buying a commodity, stock, or security in hopes that the price will increase in the future. Speculative investors make profit off the gains after the contract expiration.
However, if the commodity’s price is lower than the specified contract price, the trader could see a loss. Typically, speculation requires a greater investment risk than average investing, but oftentimes provides high returns to compensate for the risk.
Hedging
To understand hedging, it is best to compare it to insurance of sorts. When investors decide to hedge, they are protecting themselves against potential negative impacts from events. While this does not protect all negative impacts, if properly hedged, your impact from the loss will be reduced.
Hedging techniques help investors, corporations, and portfolio managers reduce their exposure to risks. It generally involves derivatives based trading strategies where the derivative gain helps offset the loss in an additional investment.
Regulation
Within the United States, futures and options markets are regulated under the Commodity Futures Trading Commission (CFTC). As self-regulatory organizations, future exchanges create and enforce their standards and rules that comply with the CFTC principles. Moreover, there is constant surveillance and compliance reviewed by a formalized department that works within the exchange.
Key Terms
Contract size
The contract size refers to the quantity of the stock or commodity that will be exchanged for each contract. In short, the contract size sets the exact quantities for each asset that is being bought or sold.
Contract value
The contract value depends on the value of the asset. The contract value of a futures contract determines the assets value. To determine the futures contract value, multiply the contract size by the value per commodity.
Tick size
A tick is commonly referred to as the minimum price fluctuations in a futures contract. Additionally, they are established in contract specifications to help track the price movement.
Tick value
The tick value regarding a future contract refers to the cash value of one tick. The value will vary from each kind of asset.
Limit move
A limit move in a features contract is the maximum amount of change in the price for the contract that is allowed daily, set by an exchange. The amount of a limit move is based off the prior day’s closing price and its purpose is to prevent extreme volatility in the market. More importantly, the price is not allowed to drop below or go above once the limit is reached.
Contract month
In future contracts, the delivery month is also called the contract month. The futures contract expires after the stock, commodity, or security is accepted and delivered on the designated date within the contract month.
First day notice
The first day notice is the first business day in the contract month where the investor who purchased the futures contract is required to take delivery of the contract’s underlying asset.
Pit trading hours
Pit trading hours is when the pit is open for trading, which many find is the most ideal time period to trade.
Electronic trading hours
Electronic trading hours are contracts that run outside of pit trading hours and overnight.
Basis
Basis is the difference between the cash value of the commodity, stock, or security and the futures value.
Convergence
As a futures contract nears its expiration the price converges naturally. Convergence is when the price of the futures contract moves towards the spot price, also known as the current price in the marketplace. This happens naturally because the futures price was set in the future.
Popular Futures Markets
The Chicago Mercantile Exchange Group reports the most heavily traded futures contracts in the world. Like all markets, futures’ volume and interest fluctuate depending on economic, political, and natural events. However, the most common markets continue to be:
- Agriculture
- Corn
- Soybeans
- Wheat
- Live Cattle
- Energy
- Crude Oil
- Natural Gas
Additionally, Eurodollar futures tend to be the most traded FX globally with lower transaction costs and diverse opportunities.
What Are the Benefits & Disadvantages of Futures?
Futures markets are very appealing to day traders since little capital is required to get started. Plus, if done correctly, these day traders tend to see large returns.
Unlike traditional day trade stocks that require at least $25,000 to get started, you can begin trading futures with $750. However, starting off with more than $750 is highly recommended. Be aware that big rewards require big risks and losses are possible.
Benefits
Future markets are very liquid: Since there are continuous buyers and sellers in the futures market; futures are traded at a high volume on the daily.
Commission costs are low: On future trades, commissions are only charged after the contract is closed. More importantly, this fee tends to be exceptionally low. Most brokerage commissions are typically 0.5% of the contract.
Great for diversification: For those looking for managing varying levels of risk, futures are great for diversifying and hedging.
More fair and efficient: No one can predict with certainty futures markets — unlike stocks that have insiders and managers who can leak information. Lastly, futures do not have issues like insider trading, making them more fair for investors.
Disadvantages
No control over future events: The biggest drawback of investing with futures is you have no control over future events. Political issues, unpredicted economic changes, and natural disasters can completely disrupt the estimate value of your futures contract.
Complicated Products: For a new trader, futures contracts can be complex to understand. Additionally, these contracts can only be traded by brokers who are registered with the CFTC.
Price Limits: As mentioned above, many commodities have a limit on how much the price can fluctuate.
Futures vs. Options
Both options and futures are great options for investors, but they carry varying risks. An option contract allows the investor the right to buy or sell shares at a specific price, without an obligation. In contrast, futures contracts require the investor to buy or sell the shares set within the contract, meaning there is no option.
Lastly, futures tend to be easier to understand and are often more liquid. However, before testing the waters alone it is worth a call to your financial advisor to help you understand your risks.
Consider Guidance From a Financial Advisor
Getting into futures can be a complicated task for new or passive investors. While they have the potential to be great investments, they do hold considerable risks. More importantly, this is why it is recommended that you consult a trusted financial advisor. They can help you sort through your options and guide you to the best futures contract that fits your investment needs.