What Are Futures?
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.
KEY TAKEAWAYS
- Futures are derivative financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and set price.
- A futures contract allows an investor to speculate on the direction of a security, commodity, or financial instrument.
- Futures are used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.
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How Do Futures Contracts Work?
Understanding Futures
Futures—also called futures contracts—allow traders to lock in the price of the underlying asset or commodity. These contracts have expiration dates and set prices that are known upfront. Futures are identified by their expiration month. For example, a December gold futures contract expires in December.
Traders and investors use the term “futures” in reference to the overall asset class. However, there are many types of futures contracts available for trading including:1
- Commodity futures such as crude oil, natural gas, corn, and wheat
- Stock index futures such as the S&P 500 Index
- Currency futures including those for the euro and the British pound
- Precious metal futures for gold and silver
- U.S. Treasury futures for bonds and other products
It’s important to note the distinction between options and futures. American-style optionscontracts give the holder the right (but not the obligation) to buy or sell the underlying assetany time before the expiration date of the contract; with European options, you can only exercise at expiration but do not have to exercise that right.2
The buyer of a futures contract, on the other hand, is obligated to take possession of the underlying commodity (or the cash equivalent) at the time of expiration and not any time before. The buyer of a futures contract can sell their position at any time before expiration and be free of their obligation. In this way, buyers of both options and futures contracts benefit from a leverage holder’s position closing before the expiration date.Pros
- Investors can use futures contracts to speculate on the direction in the price of an underlying asset.
- Companies can hedge the price of their raw materials or products they sell to protect against adverse price movements.
- Futures contracts may only require a deposit of a fraction of the contract amount with a broker.
Cons
- Investors have a risk that they can lose more than the initial margin amount since futures use leverage.
- Investing in a futures contract might cause a company that hedged to miss out on favorable price movements.
- Margin can be a double-edged sword, meaning gains are amplified but so too are losses.
Using Futures
The futures markets typically use high leverage. Leverage means that the trader does not need to put up 100% of the contract’s value amount when entering into a trade. Instead, the broker would require an initial margin amount, which consists of a fraction of the total contract value.3
The amount held by the broker in a margin account can vary depending on the size of the contract, the creditworthiness of the investor, and the broker’s terms and conditions.
The exchange where the futures contract trades will determine if the contract is for physical delivery or if it can be cash-settled. A corporation may enter into a physical delivery contract to lock in—hedge—the price of a commodity they need for production. However, most futures contracts are from traders who speculate on the trade. These contracts are closed out or netted—the difference in the original trade and closing trade price—and are a cash settlement.
Futures for Speculation
A futures contract allows a trader to speculate on the direction of movement of a commodity’s price. If a trader bought a futures contract and the price of the commodity rose and was trading above the original contract price at expiration, then they would have a profit. Before expiration, the buy trade—the long position—would be offset or unwound with a sell trade for the same amount at the current price, effectively closing the long position.
The difference between the prices of the two contracts would be cash-settled in the investor’s brokerage account, and no physical product will change hands. However, the trader could also lose if the commodity’s price was lower than the purchase price specified in the futures contract.
Speculators can also take a short or sell speculative position if they predict the price of the underlying asset will fall. If the price does decline, the trader will take an offsetting position to close the contract. Again, the net difference would be settled at the expiration of the contract. An investor would realize a gain if the underlying asset’s price was below the contract price and a loss if the current price was above the contract price.
It’s important to note that trading on marginallows for a much larger position than the amount held by the brokerage account. As a result, margin investing can amplify gains, but it can also magnify losses. Imagine a trader who has a $5,000 broker account balance and is in a trade for a $50,000 position in crude oil. If the price of oil moves against its trade, it can incur losses that far exceed the account’s $5,000 initial margin amount. In this case, the broker would make a margin call requiring additional funds to be deposited to cover the market losses.
Futures for Hedging
Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges are using—or in many cases producing—the underlying asset.
For example, corn farmers can use futures to lock in a specific price for selling their corn crop. By doing so, they reduce their risk and guarantee they will receive the fixed price. If the price of corn decreased, the farmer would have a gain on the hedge to offset losses from selling the corn at the market. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable market price.
