A futures contract is an agreement to buy or sell an asset at a future date at an agreed-upon price. Futures contracts are standardized agreements that typically trade on an exchange. One party agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party to the contract agrees to provide it.
The futures market can be used by many kinds of financial players, including investors and speculators as well as companies that want to take physical delivery of the commodity or supply it. To decide whether futures deserve a spot in your investment portfolio, consider the following:
Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel:
An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.
A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices.
Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.
In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it’s the basis of their business. They use the futures market to manage their exposure to the risk of price changes.
But not everyone in the futures market wants to exchange a product in the future. These people are investors or speculators, who seek to make money off price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. This type of trader can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they’re just in the market to wager on price movements.
Commodities represent a big part of the futures-trading world, but it’s not all about hogs, corn and soybeans. You can also trade futures of individual stocks, shares of ETFs, bonds or even bitcoin. Some traders like trading futures because they can take a substantial position (the amount invested) while putting up a relatively small amount of cash. That gives them greater potential for leverage than just owning the securities directly.
Most investors think about buying an asset anticipating that its price will go up in the future. In short-selling, investors do the opposite always; borrow money to expect an asset’s price will fall so they can buy later at a lower price.
One common application for futures relates to the U.S. stock market. Someone wanting to hedge exposure to stocks may short-sell a futures contract on the Standard & Poor’s 500. If stocks fall, he makes money on the short, balancing out his exposure to the index. Conversely, the same investor may feel confident in the future and buy a long contract – gaining a lot of upside if stocks move higher.
Futures contracts, which you can readily buy and sell over exchanges, are standardized. Each futures contract will typically specify all the different contract parameters:
The unit of measurement.
How the trade will be settled – either with physical delivery of a given quantity of goods, or with a cash settlement.
The quantity of goods to be delivered or covered under the contract.
The currency unit in which the contract is denominated
The currency in which the futures contract is quoted.
Grade or quality considerations, when appropriate. For example, this could be a certain octane of gasoline or a certain purity of metal.
If you plan to begin trading futures, be careful because you don’t want to have to take physical delivery. Most casual traders don’t want to be obligated to sign for receipt of a trainload of swine when the contract expires and then figure out what to do with it.
Many speculators borrow a substantial amount of money to play the futures market because it’s the main way to magnify relatively small price movements to potentially create profits that justify the time and effort. But borrowing money also increases risk: If markets move against you, and do so more dramatically than you expect, you could lose more than you invested.
Leverage and margin rules are a lot more liberal in the futures and commodities world than they are for the securities trading world. A commodities broker may allow you to leverage 10:1 or even 20:1, depending on the contract, much higher than you could obtain in the stock world. The exchange sets the rules.
The greater the leverage, the greater the gains, but the greater the potential loss, as well: A 5 percent change in prices can cause an investor leveraged 10:1 to gain or lose 50 percent of her investment. This volatility means that speculators need the discipline to avoid overexposing themselves to any undue risk when trading futures.
If such risk seems too much and you’re looking for a way to shake up your investment strategy, consider options instead.
It is relatively easier to get started trading futures. Open an account with a broker that supports the markets you want to trade. A futures broker will likely ask about your experience with investing, income and net worth. These questions are designed to determine the amount of risk the broker will allow you to take on, in terms of margin and positions.
There’s no industry standard for commission and fee structures in futures trading. Every broker provides varying services. Some provide a good deal of research and advice, while others simply give you a quote and a chart.
Some sites will allow you to open up a virtual trading account. You can practice trading with “paper money” before you commit real dollars to your first trade. This is an invaluable way to check your understanding of the futures markets and how the markets, leverage and commissions interact with your portfolio. If you’re just getting started, we highly recommend spending some time trading in a virtual account until you are sure you have the hang of it.
Even experienced investors will often use a virtual trading account to test a new strategy. Depending on the broker, they may allow you access to their full range of analytic services in the virtual account.