Key Takeaways
- A futures contract is an agreement to trade a commodity, currency, or stock at a set price, amount, and date.
- Businesses use futures contracts to hedge risk, and traders may use them to place speculative bets.
- Futures can be traded with over 30x leverage and are risky because of that leverage.
How Do Futures Work?
Futures contracts are derivatives that lock the price and amount of a commodity, currency, or stock trade in advance. Futures generally trade on an exchange such as the CME Group, where speculators can be matched with one another and business owners to trade futures contracts.
The date set in the futures contract is called the expiry date and trade in ticks. Ticks are the smallest price increment for a trade and are generally one cent. The exception is S&P 500 futures, which have ticks equal to a quarter on an index point.
Note
Settling a futures contract on expiry can either occur with the delivery of the underlying or in cash, depending on the type of contract you have. For example, stock index futures are cash settled.
Futures that trade on an exchange generally have a standardized contract, set by the exchange, and have no counterparty risk because the exchange clears all trades.
Why Trade Futures?
Business owners generally use futures contracts to hedge risk. For example, a corn farmer can use a futures contract to lock in a certain price for their corn months ahead of time. An airline can use futures to hedge against the risk of rising fuel prices.
Traders can use futures contracts to speculate. Individuals can trade futures using a brokerage account such as Schwab or TDAmeritrade.
Futures trading is known for its leverage. Where equity trading typically requires 50% equity, futures trading can be done with as little as 3%. That means for every $1,000 in the trade, you only need to put $30 down. This level of leverage makes trading futures one of the riskiest investments.
Note
Since futures are extremely risky investments, they may not be suitable for all individual investors.
Example of Futures
Let’s say a soybean farmer is worried that soybean prices will collapse prior to harvest and wants to lock in a price for part of the potential harvest now. The farmer can use a brokerage account or even the CME Group website to look through current quotes for different futures contracts (they are designated by date, so futures due in November would be called NOV Soybean Futures).
If the farmer finds a price that guarantees sufficient profit, they can sell the contract and deliver the soybeans at the contract date.
Types of Futures
Futures can be based on a wide variety of underlying assets. Here are some different types of futures contracts:
- Financial futures: Financial futures include stock indexes, commodity indexes, and U.S. Treasury debt instruments.
Note
Single stock futures that were introduced in the U.S. in 2012 stopped trading in 2020 after OneChicago—the exchange where they were traded—shut down.
- Currency futures: There are several currencies available for trading via futures contracts, including everything from the U.S. dollar and the Brazilian real to cryptocurrencies such as bitcoin and ethereum.
- Energy futures: Energy futures include crude oil, natural gas, and other petroleum products such as gasoline and heating oil as well as ethanol.
- Agricultural futures: These include grain, livestock, and food and fiber futures such as wheat, cattle, and coffee respectively.
- Metal futures: Precious metals such as gold and silver, and industrial metals like copper can be traded.
Futures Costs and Trading Requirements
Futures trading costs are commissions to the broker. For example, Charles Schwab charges $2.25 per trade. Exchange and regulatory fees are also charged. Exchange fees vary by product, and regulatory fees are two cents per contract.
Note
Futures trading requirements are far more lax than equity trading requirements. For day traders who trade stocks, there’s a minimum margin requirement of $25,000. For futures traders, depending on the type of contract, a typical margin account could be a few hundred dollars.
Futures vs. Options
Options and futures are both derivatives; the difference is obligation. Futures contract agreements obligate the seller to deliver on the contracts’ dates. Options contracts give the buyer the right, but not the obligation, to either buy or sell the contract by the maturity date.
Alternatives to Futures
Investors who want to speculate on commodities but don’t want to use margin or set up a special account to trade futures can use exchange-traded funds (ETFs) or exchange-traded notes (ETNs) to invest in commodities.
Frequently Asked Questions (FAQs)
What are Dow futures?
Dow futures are contracts based on the Dow Jones Industrial Average. Dow futures can be used to predict short-term stock-market movements while the market is closed or to speculate on the market direction over the medium term.
How do you trade futures?
Futures are traded on an exchange such as the CME Group through brokerages such as TDAmeritrade and Charles Schwab.
FAQs
Definition: A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future.
What is a futures contract an example of? ›
Futures are derivatives, which are financial contracts whose value comes from changes in the price of the underlying asset. Stock market futures trading obligates the buyer to purchase or the seller to sell a stock or set of stocks at a predetermined future date and price.
Why would you buy a futures contract? ›
Narrator: One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change.
What are futures for dummies? ›
Futures trading is a financial strategy that allows you to buy or sell a specific asset at a predetermined price at a specified time in the future. It's a way to potentially profit from the price movements of commodities, stocks, and other assets.
What are futures vs stocks? ›
Futures contracts expire; shares of stock don't
A futures contract, in contrast, has a fixed life. A crude oil June 2023 futures contract, for example, expires on a certain date based on the contract specifications.
Are futures high risk? ›
Yes, it is possible to lose more money than you initially invested in futures trading. This is because futures contracts are leveraged, which means you can control a large position with a relatively small amount of investment upfront. 9 While leverage can amplify your gains, it can also magnify your losses.
What is a real life example of futures? ›
Futures contract example
For example, Crude Oil is currently selling at $60 a barrel, and a futures contract for $65 per barrel is available for three months' time. As you believe the price of WTI will rise beyond $65 by the time of expiry, you buy the contract. The market actually rises to $75.
How do futures work? ›
Futures are derivative contracts to buy or sell an asset at a future date at an agreed-upon price. Futures contracts allow players to secure a specific price and protect against future price swings. You can buy futures on commodities like coffee, stock indexes like the S&P 500 or cryptocurrencies like Bitcoin.
What are the disadvantages of futures contracts? ›
Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.
What are the cons of futures trading? ›
Following are the risks associated with trading futures contracts:
- Leverage. One of the chief risks associated with futures trading comes from the inherent feature of leverage. ...
- Interest Rate Risk. ...
- Liquidity Risk. ...
- Settlement and Delivery Risk. ...
- Operational Risk.
Futures are standardized and traded on regulated exchanges, making them highly transparent and liquid. Futures trading involves leverage and margin requirements, which can amplify both profits and losses.
How much money is required to buy a futures contract? ›
How much funds do I need to trade futures? Trading in futures contracts involves margin payment. The volume of margin will depend on the stake size. However, most brokers will ask for at least 10 percent upfront margin to place a trade.
Why do people buy futures instead of options? ›
Futures offer higher potential profits but also higher risk, while options provide limited profit potential with capped losses. However, Options require lower upfront capital compared to futures.
Who buys futures contracts? ›
The first group of traders are commodity producers and processors, also referred to as "commercials"; they could include oil companies, grain millers, and precious metals miners. There are also "speculators," such as big banks, hedge funds, and individuals who trade for a living, along with retail traders.
What is a futures contract and how does it work? ›
A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Typically, futures contracts are traded electronically on exchanges such as the CME Group, the largest futures exchange in the United States.
What is the difference between a contract and a futures contract? ›
A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.
What is an example of futures trading? ›
For example, gold futures trade in contracts for 100 troy ounces. So, if gold is trading for about $2,000 per ounce, each futures contract is $200,000 in value. Oil is measured in barrels, which are about 42 gallons, and each futures contract is for 100 barrels.
What are the pros and cons of futures trading? ›
The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.
