Futures trading involves contracts to buy or sell a specific underlying asset at a predetermined future date and price. This asset can range from commodities like crude oil to financial instruments like stock market indices. Understanding “What Is Futures Trading” is crucial for investors looking to diversify their portfolios or hedge against market volatility. Futures contracts obligate the buyer to purchase or the seller to sell the underlying asset at the agreed-upon price upon expiration, regardless of the prevailing market price.
:max_bytes(150000):strip_icc()/dotdash_Final_What_Are_Futures_Dec_2020-01-85ad1c704e3c4c59959f2b03c19e84a7.jpg “A trader analyzing real-time futures market data on a multi-screen setup.”)
Commonly, futures trading refers to contracts based on the future value of securities in the stock market. These contracts track individual company shares or stock market indices like the S&P 500, Dow Jones Industrial Average, or Nasdaq. Exchanges such as the Chicago Mercantile Exchange (CME) also offer futures on physical commodities, bonds, and even weather events.
Understanding the Basics of Futures
Key Takeaways
- Derivatives: Futures are derivatives, meaning their value is derived from the price fluctuations of an underlying asset.
- Obligation: Stock market futures trading creates an obligation for the buyer to purchase, or the seller to sell, a specific stock or a collection of stocks at a predetermined price and date in the future.
- Hedging Tool: Futures serve as a tool to hedge against potential price movements in stocks, indexes, or commodities, mitigating the risk of losses from unfavorable price changes.
The Role of Underlying Assets in Futures Trading
Futures contracts allow traders to lock in the price of an underlying asset. These contracts come with predefined expiration dates and set prices known upfront. Stock futures are typically organized by month, each having specific expiration dates. The underlying assets can vary widely:
- Commodity Futures: Based on raw materials like crude oil, natural gas, corn, and wheat.
- Cryptocurrency Futures: Track price movements in digital assets like Bitcoin or Ethereum.
:max_bytes(150000):strip_icc()/dotdash_Final_What_Are_Futures_Dec_2020-01-85ad1c704e3c4c59959f2b03c19e84a7.jpg “Real-time cryptocurrency prices, indicating market volatility and potential opportunities for futures trading.”) - Currency Futures: Encompass currencies like the Euro and British Pound.
- Energy Futures: Include crude oil, natural gas, gasoline, and heating oil.
- Equities Futures: Based on individual stocks and groups of stocks traded in the market.
- Interest Rate Futures: Used for speculation or hedging against changes in interest rates, focusing on treasuries and other bonds.
- Precious Metal Futures: Involve gold and silver.
- Stock Index Futures: Track indices like the S&P 500.
Important Considerations
Buyers of futures contracts are generally obligated to take possession of the underlying stocks or shares at the expiration date, though they often sell their positions before expiration. The nature of this obligation distinguishes futures from options, where the buyer has the right, but not the obligation, to buy or sell the underlying asset.
How Futures Trading Operates
The standardized nature of futures contracts—in terms of quantity, quality, and asset delivery—facilitates trading on futures exchanges. These contracts commit the buyer to purchase and the seller to sell a stock or shares in an index at a predetermined date and price. This standardization enhances market transparency, improves liquidity, and aids in accurate pricing.
Stock futures are organized by month and have specific expiration dates. For instance, futures contracts for the S&P 500 may expire in March, June, September, and December. The contract nearest to expiration is known as the “front-month” contract, typically seeing the most trading activity. As a contract approaches expiration, traders often “roll over” their positions to the next available contract month. Short-term traders tend to focus on front-month contracts, while long-term investors may look further out.
In S&P 500 index futures trading, buying a futures contract means agreeing to purchase shares in the index at a set price in the future. If the index rises, the value of the futures contract increases, allowing the trader to sell the contract for a profit before expiration. Conversely, selling a futures contract reflects a belief that a specific equity will decline in value. If the market declines as expected, the trader can buy back the contract at a lower price, profiting from the difference.
Tip
Settlement methods for futures contracts vary depending on the underlying asset. Physical delivery is common for commodities such as oil, gold, and wheat. However, futures based on stocks and stock indexes typically involve cash settlement.
Speculation in Futures Trading
Futures contracts provide traders with opportunities to speculate on the price of an asset. Profit is realized if a trader buys a futures contract and the price at expiration is higher than the original contract price. Conversely, losses occur if the commodity’s price is lower than the purchase price specified in the futures contract. Before expiration, the long position can be sold at the current price to close the position.
Traders can also take a short speculative position if they anticipate a price decline. If the price falls, the trader can offset the position to close the contract, settling the net difference at expiration. Profit is made if the underlying asset’s price is below the contract price, and losses occur if it’s above the contract price.
Consider a scenario where a trader buys a futures contract on the S&P 500 when the index is at 5,000 points, with delivery in three months. If each contract represents $50 times the index level, one contract is worth $250,000. Instead of needing $250,000 upfront, futures trading requires traders to post a margin, a fraction of the contract’s total value. If the initial margin is 10%, the trader only deposits $25,000. If the index falls by 10% to 4,500 points, the contract’s value drops to $225,000, resulting in a $25,000 loss, equivalent to a 100% loss on the initial margin. This example highlights the potential for significant gains and losses due to leverage.
Hedging with Futures
Futures trading serves as a valuable hedging tool to protect against unfavorable price movements in underlying assets. Instead of speculating, hedging aims to mitigate potential losses. For example, a mutual fund manager overseeing a $100 million portfolio that tracks the S&P 500 can use S&P 500 futures contracts to hedge against potential short-term market volatility.
Assuming the S&P 500 is at 5,000 points and each futures contract represents the index times a multiplier of $250 per index point, the value hedged by one futures contract is $1,250,000. To hedge the entire $100 million portfolio, approximately 80 futures contracts are needed. Selling these contracts can lead to two possible outcomes:
- If the S&P 500 drops by 10%, the portfolio would likely lose $10 million. However, the value of the futures contracts sold by the manager would increase, offsetting this loss. With a gain of $125,000 per contract, the total gain from 80 contracts would be $10 million, effectively protecting the portfolio from the downturn.
- If the S&P 500 increases, the portfolio’s value would rise, but the manager would experience a loss in the futures position, offsetting the gain.
This is acceptable since the primary goal was to hedge against a downturn.
Advantages and Disadvantages of Futures Trading
Futures trading presents both advantages and disadvantages. Typically, futures trading involves leverage, requiring an initial margin that is a small percentage of the contract value. The margin amount depends on factors such as the contract size, the investor’s creditworthiness, and the broker’s terms and conditions.
Futures contracts serve as a vital tool for hedging against price volatility, allowing companies to plan budgets and protect potential profits. However, investors risk losing more than the initial margin due to the leverage involved.
Pros:
- Potential for speculation gains
- Effective hedging capabilities
- Favorable trading conditions
:max_bytes(150000):strip_icc()/dotdash_Final_What_Are_Futures_Dec_2020-01-85ad1c704e3c4c59959f2b03c19e84a7.jpg “A visual representation of leveraged futures trading, showing how a small margin can control a large asset value.”)
Cons:
- Higher risk due to leverage
- Potential for missing out on price moves when hedging
- Margin requirements act as a double-edged sword
Regulatory Oversight of Futures Markets
The Commodity Futures Trading Commission (CFTC) regulates the futures markets. Created by Congress in 1974, the CFTC is a federal agency that ensures the integrity of futures market prices by preventing abusive trading practices and fraud, as well as regulating brokerage firms engaged in futures trading.
Futures vs. Stocks: Why Choose Futures?
One key advantage of futures trading over stocks is the high leverage, enabling investors to control significant assets with a relatively small amount of capital. However, this leverage also implies higher risks. Additionally, futures markets are typically open around the clock, providing the flexibility to trade outside traditional market hours and react swiftly to global events.
Profitability: Futures vs. Options
The profitability of futures versus options hinges on an investor’s strategy and risk tolerance. Futures tend to offer higher leverage and potentially greater profits when predictions are accurate, but they come with heightened risks. Options provide the safety of a nonbinding contract, limiting potential losses.
What Happens at Expiration?
When equities serve as the underlying asset, traders holding futures contracts until expiration settle their positions in cash, either paying or receiving a cash settlement based on whether the underlying asset increased or decreased in value during the investment period. However, some futures contracts require physical delivery of the underlying asset.
The Bottom Line on Futures Trading
Futures contracts offer opportunities for price speculation and risk mitigation against potential market downturns. However, traders must consider the drawbacks, such as the potential for additional losses if market predictions are incorrect, as well as the volatility introduced by the daily settlement of futures prices. Understanding “what is futures trading” and its implications is key to informed decision-making.
