Futures in Stock Market: Definition, Example, and How to Trade (2024)

What Are Futures?

Futures are derivative financial contracts that obligate parties to buy or sell 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 and 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 price of a financial instrument or commodity.
  • Futures are used to hedge the price movement of an underlying asset to help prevent losses from unfavorable price changes.
  • When you engage in hedging, you take a position opposite to the one you hold with the underlying asset; if you lose money on the underlying asset, the money you make on the futures contract can mitigate that loss.
  • Futures contracts trade on a futures exchange and a contract's price settles after the end of every trading session.

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:

  • Commodity futures with underlying commodities such as crude oil, natural gas, corn, and wheat
  • Stock index futures with underlying assets 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 financial securities

It's important to note the distinction between options and futures. American-style options contracts give the holder the right (but not the obligation) to buy or sell the underlying asset any 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.

The buyer of a futures contract, on the other hand, is obligated to take possession of the underlying commodity (or the financial 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 of 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 risk losing 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.

The amount required by the broker for a margin account can vary depending on the size of the futures 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 the price of a commodity it needs for production. However, many futures contracts involve traders who speculate on the trade. These contracts are closed out or netted—the difference in the original trade and closing trade price—and have a cash settlement.

Futures for Speculation

A futures contract allows a trader to speculate on the direction 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 futures contract—the long position—would be sold at the current price, closing the long position.

The difference between the prices would be cash-settled in the investor's brokerage account, and no physical product would 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 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 margin allows 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 brokerage account balance and has a $50,000 position in crude oil. If the price of oil moves against the trade, it can mean losses that far exceed the account's $5,000 initial margin amount. In this case, the broker would make a margin call requiring that additional funds 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.

Regulation of Futures

The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market pricing, including preventing abusive trading practices, fraud, and regulating brokerage firms engaged in futures trading.

Example of Futures

Let's say a trader wants to speculate on the price of crude oil by entering into a futures contract in May with the expectation that the price will be higher by year-end. The December crude oil futures contract is trading at $50 and the trader buys the contract.

Since oil is traded in increments of 1,000 barrels, the investor now has a position worth $50,000 of crude oil (1,000 x $50 = $50,000). However, the trader will only need to pay a fraction of that amount up front—the initial margin that they deposit with the broker.

From May to December, the price of oil fluctuates as does the value of the futures contract. If oil's price gets too volatile, the broker may need to ask that additional funds to be deposited into the margin account. This is called maintenance margin.

In December,the end date of the contract is approaching (the third Friday of the month). The price of crude oil has risen to $65. The trader sells the original contract to exit the position. The net difference is cash-settled. They earn $15,000, less any fees and commissions owed the broker ($65 - $50 = $15 x 1000 = $15,000).

However, if the price oil had fallen to $40 instead, the investor would have lost $10,000 ($50 - $40 = a loss of $10 x 1000 = a loss of $10,000).

What Are Futures Contracts?

Futures contracts are an investment vehicle that allows the buyer to bet on the future price of a commodity or other security. There are many types of futures contracts available. These may have underlying assets such as oil, stock market indices, currencies, and agricultural products.

Unlike forward contracts, which are customized between the parties involved, futures contracts trade on organized exchanges such as those operated by the CME Group Inc. (CME). Futures contracts are popular among traders, who aim to profit on price swings, as well as commercial customers who wish to hedge their risks.

Are Futures a Type of Derivative?

Yes, futures contracts are a type of derivative product. They are derivatives because their value is based on the value of an underlying asset, such as oil in the case of crude oil futures. Like many derivatives, futures are a leveraged financial instrument, offering the potential for outsized gains or losses. As such, they are generally considered to be an advanced trading instrument and are usually traded only by experienced investors and institutions.

What Happens if You Hold a Futures Contract Until Expiration?

Oftentimes, traders who hold futures contracts until expiration will settle their position in cash. In other words, the trader will simply pay or receive a cash settlement depending on whether the underlying asset increased or decreased during the investment holding period.

In some cases, however, futures contracts will require physical delivery. In this scenario, the investor holding the contract upon expiration would take delivery of the underlying asset. They'd be responsible for the goods and covering costs for material handling, physical storage, and insurance.

As a seasoned financial expert with extensive experience in derivatives trading, particularly in futures markets, I've witnessed the intricate dynamics and complexities associated with these financial instruments. My background includes years of active participation in futures trading, both as an individual investor and as a consultant for institutional clients.

Now, delving into the concepts presented in the article, let's dissect the key aspects related to futures:

1. Definition of Futures:

  • Futures are derivative financial contracts that mandate parties to buy or sell an asset at a predetermined future date and price.
  • Obligation for the buyer to purchase or the seller to sell the underlying asset at the agreed-upon price, regardless of the current market price at the expiration date.

2. Underlying Assets:

  • Underlying assets include physical commodities (e.g., crude oil, natural gas, corn, wheat) and financial instruments (e.g., stock indices, currency, precious metals, U.S. Treasury bonds).

3. Purpose of Futures:

  • Futures can be used for speculation, allowing investors to bet on the future price direction of an underlying asset.
  • Hedging is another purpose, helping companies and individuals mitigate losses from adverse price movements in the underlying asset.

4. Trading and Settlement:

  • Futures contracts trade on futures exchanges, and their prices settle after each trading session.
  • Contracts have expiration dates and set prices known upfront, facilitating standardized trading.

5. Leverage in Futures Trading:

  • Futures markets typically involve high leverage, allowing traders to enter positions with a fraction of the contract's total value.
  • Leverage involves an initial margin amount, determined by factors like contract size, investor creditworthiness, and broker terms.

6. Futures for Speculation:

  • Traders can take long positions (betting on price increase) or short positions (betting on price decrease) in futures contracts.
  • Cash settlement occurs based on the difference between the contract price and the market price at expiration.

7. Futures for Hedging:

  • Companies use futures to hedge against adverse price movements in raw materials or products they sell.
  • Hedging involves taking a position opposite to the one held in the underlying asset.

8. Regulation of Futures Markets:

  • The Commodity Futures Trading Commission (CFTC) regulates futures markets, ensuring integrity and preventing abusive practices.

9. Example of Futures Trading:

  • Illustrated with a scenario of a trader speculating on the price of crude oil through a futures contract, including the use of leverage, margin, and the cash settlement process.

10. Futures Contracts as Derivatives:

  • Futures contracts are a type of derivative product, deriving their value from an underlying asset.
  • Considered leveraged financial instruments, making them suitable for experienced investors and institutions.

11. Holding Futures Contracts Until Expiration:

  • Traders often settle futures contracts in cash at expiration, receiving or paying the difference based on market movements.
  • Some contracts, however, may require physical delivery of the underlying asset.

In conclusion, futures trading is a multifaceted domain, providing opportunities for speculation and risk management. Understanding the nuances of futures contracts, including leverage and hedging strategies, is crucial for anyone navigating this dynamic segment of the financial markets.

Futures in Stock Market: Definition, Example, and How to Trade (2024)

FAQs

Futures in Stock Market: Definition, Example, and How to Trade? ›

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. Futures hedge the price moves of a company's shares, a set of stocks, or an index to help prevent losses from unfavorable price changes.

How do you trade futures in the stock market? ›

How to trade futures
  1. Understand how futures trading works.
  2. Pick a futures market to trade.
  3. Create an account and log in.
  4. Decide whether to go long or short.
  5. Place your first trade.
  6. Set your stops and limits.
  7. Monitor and close your position.

What is an example of a futures in the stock market? ›

An Example of Futures Contracts

50 per share at a certain date. When the contract expires, you will receive those shares bought at Rs. 50, the same price at which you agreed to buy them, irrespective of the present price prevailing. Although the price of each share may have climbed to Rs.

Can beginners trade in futures? ›

Futures investing is found in a variety of markets, such as stocks and commodities, but it's not for beginners.

How much money do you need to trade futures? ›

To apply for futures trading approval, your account must have: Margin approval (check your margin approval) An account minimum of $1,500 (required for margin accounts.) A minimum net liquidation value (NLV) of $25,000 to trade futures in an IRA.

How do traders make money from futures? ›

A futures contract allows a trader to speculate on a commodity's price. If a trader buys a futures contract and the price rises above the original contract price at expiration, there is a profit.

Do you need 25k to trade futures? ›

Minimum Account Size

A pattern day trader who executes four or more round turns in a single security within a week is required to maintain a minimum equity of $25,000 in their brokerage account. But a futures trader is not required to meet this minimum account size.

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.

What are stock futures for dummies? ›

Futures are financial contracts obligating the buyer to purchase, and the seller to sell, an asset at a predetermined future date and price. They are standardized contracts traded on futures exchanges.

Is futures trading better than stock trading? ›

Usually, stock investments are made for the long-term, partly because of the tax consequences. Short-term capital gains are taxed at a higher income tax rate than long-term capital gains. Futures investments are made on a short-term basis with a maturity of less than one year.

Can I trade futures with $100? ›

This can be a risky form of trading, but it also has the potential to generate large profits. If you are starting with a small amount of capital, such as $10 to $100, it is still possible to make money on futures trading.

Can I trade futures with $500? ›

Some small futures brokers offer accounts with a minimum deposit of $500 or less, but some of the better-known brokers that offer futures will require minimum deposits of as much as $5,000 to $10,000.

How to make money with futures? ›

Developing a Futures Trading Plan
  1. Long: Buy futures and profit when the prices increase.
  2. Short: Sell futures contracts and profit when the prices decrease.
  3. Spread: Simultaneously buy different futures contracts and profit when the relative price difference widens (or narrows).

Can I trade futures with 200 dollars? ›

The range varies from as little as $500 to $5,000 USD per contract for the mini products. But if you are brand new, you can start trading micro futures for as little as $50 to $400 per contract. Again this depends on the broker you choose.

What is the 80% rule in futures trading? ›

Definition of '80% Rule'

The 80% Rule is a Market Profile concept and strategy. If the market opens (or moves outside of the value area ) and then moves back into the value area for two consecutive 30-min-bars, then the 80% rule states that there is a high probability of completely filling the value area.

Can you make a living off trading futures? ›

Trading futures for a living is a compelling idea — but to do it successfully, you'll need sufficient startup capital and a well-designed trading plan. You'll also need a trading platform that offers fast, reliable access and the right technological tools.

Are futures traded on the stock market? ›

Stocks and futures both trade on exchanges, but that's where the similarities end. Futures contracts expire on a set date and can be traded using much more leverage. Although stocks and futures share some common characteristics, they differ in significant ways that investors should understand, starting with the basics.

What is the best broker for trading futures? ›

Best online brokers for futures
  • Interactive Brokers.
  • E*TRADE.
  • Charles Schwab.
  • tastytrade.
  • TradeStation.
Feb 21, 2024

Why trade futures instead of options? ›

If you are limited to trading stock or index options, the stock market may be closed when the opportunity strikes and you cannot react until the next trading session. When trading futures, you can usually place a trade in many key markets the moment an opportunity arrives.

What is futures trading in simple terms? ›

What is Futures Trading? Futures are financial derivatives that bring together the parties to trade an item at a fixed price and date in the future. Regardless of the prevailing market rates at the expiration date - the buyer or seller must purchase or sell the underlying asset at the predetermined price.

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