What are futures? A guide to futures trading

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Trading futures can provide opportunities for a range of investors. Some investors may trade futures contracts in order to hedge against risk or to speculate on the price movements of a given asset or security — or because their business will benefit if they lock in a commodity at a certain price. A large trucking company may buy oil futures as a way to protect itself against sudden spikes in the price of oil, for example.

A futures contract requires both parties to honor the terms, no matter what the price is in the market when the contract expires.

If you want to trade futures, there are various ways they can fit into your portfolio or plan.

Related: How does a margin account work?

What Are Futures?

Futures are derivatives that take the form of a contract in which two traders agree to buy or sell an asset for a specified price at a future date. Popular underlying assets for futures may include physical commodities like gold, corn or oil, as well as currencies (including crypto), or financial instruments like stocks. The most commonly traded futures contracts use standardized terms and are traded on a futures exchange.

For example, if you want to buy or sell corn futures, one contract would equal 5,000 bushels and be traded via the Chicago Board of Trade (CBOT). Oil is traded on the Chicago Mercantile Exchange (CME), and one oil futures contract equals 1,000 barrels of oil.

Traders buy and sell in increments specified by the contract. To buy 50,000 bushels of corn or 10,000 barrels of oil, you’d buy 10 contracts of each.

Given the quantities and dollar amounts of these trades, investors use leverage, thereby paying only a fraction of the total cost of the position (more on margin trading below).

Types of Futures

Futures contracts allow investors to make bets on the prices of a wide array of assets:

  • Commodity futures, which allow investors to buy or sell physical goods like crude oil, pork bellies, natural gas, orange juice, corn, wheat and more
  • Financial futures, including index contracts and interest rate or debt contracts
  • Precious metal futures allow investors to bet on the future prices of gold, platinum and silver
  • Currency futures for fiat currencies like the euro, yen, the British pound, as well as cryptocurrencies
  • U.S. Treasury futures allow investors to make bets on the future value of government bonds

What are stock futures? Like futures contracts where the underlying is a physical commodity, some futures are tied to shares of a single stock or ETF. Stock index futures, however, are tied to the price movements of an index like the S&P 500 index.

What are Futures Contracts?

A quick recap as we explore: What are futures, and how do futures work? First, a futures contract obliges the buyer to buy a certain asset, or the seller to sell an asset, at an agreed-upon price, by a certain date. Each party must fulfill the terms of the contract, no matter what the market price or spot price is when the contract expires (or trade the contract before the expiration).

Futures contracts are standardized, as noted above, and each contract also spells out the contract terms, which includes, among other things:

  • The unit of the trade (e.g., tons, gallons, bushels, etc.).
  • The grade or quality of the commodity, where relevant. For example, there are different types of corn, oil, soy, etc.
  • Terms of settlement (e.g., physical delivery or a cash settlement).
  • Quantity of goods covered by the contract.
  • Currency in which the contract is priced.

A futures contract allows investors to speculate on the direction of the underlying asset, either long or short, using leverage. (Leverage means the trader doesn’t have to put up the full amount of the contract. Instead, futures traders use a margin account.)

How Do Futures Work?

In order to answer the question, How do futures work?, it’s important to understand two key aspects of futures trading: hedging and speculation.

Hedging with Futures

Hedging is a big reason why investors buy futures contracts: It’s a way to protect against losses resulting from price changes in commodities.

Recommended: Why is it risky to invest in commodities?

Among the businesses that hedge using futures, the goal is to reduce the risk they face from unexpected price movements, and to guarantee the price they pay or receive for a particular asset.

If a large food manufacturer wants to lock in the price of corn, for example, they might enter into a contract for $10 a bushel. Since corn contracts are typically standardized at 5,000 bushels per contract, the total amount of the futures contract would be $50,000 ($10 x 5,000), to be delivered in six months. Entering into this futures contract would offer the buyer some protection against the possibility of rising corn prices in the future.

Let’s say the price of corn does rise to $12/bushel by the time the contract expires. In that case, the buyer still only pays the agreed-upon price of $10/bushel, even though the spot price is now $12/bushel.

For the corn producer in this scenario, even though it turned out that the futures contract terms weren’t quite as favorable as the actual market price — the contract guaranteed they would get at least $10/bushel, which provided a hedge against a potentially bigger loss.

Speculating with Futures

Although it’s possible to settle a futures contract for the physical asset specified in the contract, most futures contracts are cash-settled. That’s because speculation on price movements is one of the main reasons that investors purchase futures contracts. A futures contract gives traders the opportunity to speculate whether a commodity will go up or down and potentially profit from the price change.

If the underlying asset of the futures contract — such as gold, oil or corn — is above the price specified in the futures contract, then the investor can sell that contract for a profit before it expires. In that case, the contract would sell for the difference between the market price of the underlying commodity and the purchase price as specified in the contract.

In such a transaction, the underlying commodities don’t change hands between the counterparties of the contract. Instead, the trade would be cash-settled in the brokerage account of the investor.

Alternatively, an investor using futures for speculation could lose money if the price of the commodity is lower than the purchase price specified in the futures contract.

Difference Between Options and Futures

There are other financial derivatives with similar characteristics to futures contracts. One of the most common of these is options contracts. American-style options grant the buyer the right, but not the obligation, to buy or sell the contract’s underlying asset at any time until the contract expires.

Unlike a futures contract, however, options contracts don’t require the investor to purchase or sell the underlying asset. The investor can simply let the option expire. A futures contract, on the other hand, obligates the buyer to purchase the underlying asset, or to pay the seller of the futures contract the cash equivalent of that asset at the time of the contract’s expiration.

Recommended: How to trade options

How to Trade Futures

It’s common for some brokerages to have their own futures-trading capabilities, as well as their own rules about what an investor needs in terms of assets in order to trade futures contracts. Be sure to verify what those requirements are before selecting a broker.

Once you’re eligible to open a margin account and trade futures, those contracts trade on different exchanges, such as the Chicago Mercantile Exchange (CME), ICE Futures U.S. (Intercontinental Exchange) and the CBOE Futures Exchange (CFE).

Most investors in futures contracts have no interest in either receiving or having to deliver the physical commodities that underlie these contracts. Rather, they’re interested in the cash profit. The means of doing so is to trade the futures contract before its expiration date.

The standardized nature of most futures makes it so that a great many (but not all) futures contracts will expire on the third Friday of each month. Some commodities are seasonal, and only trade during specific months. High-grade corn trades on the CBOT in March, May, July, September and December, for example.

The Risks of Trading Futures

Owing to the nature of futures trading, i.e., the binding nature of the contracts and the use of leverage, there are some obvious risks to bear in mind.

In a speculative trade, a futures contract allows you to bet on a commodity’s price movement. If you bought a futures contract, and at expiration the price of the commodity was trading above the original contract price, you’d see a profit. However, you could also lose if the commodity’s price was lower than the purchase price specified in the futures contract.

The potential risks here can be greater than they seem because trading on margin permits a much larger position than the actual amount held by the brokerage. As a result, margin investing can amplify gains, but it can also magnify losses.

Imagine a trader who has $5,000 in their brokerage account and is in a trade for a $50,000 position in crude oil. If the price of oil moves against the trade, the losses could 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.

Speculators can also take a short position if they believe the price of the underlying asset will decline. 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. Again, using leverage to place these bets, long or short, can potentially expose investors to more risk than they intended.

FAQs

What are futures trading hours?

Unlike the stock market, which is active five days a week from 9:30 a.m. to 4 p.m. Eastern Time, you can trade futures nearly 24 hours a day, six days a week — from 6 p.m. on Sunday to 5 p.m. on Friday — depending on the asset or commodity. Check local times.

Can you day trade futures?

Yes. Some investors believe that trading futures is well suited to day trading, as the price of the underlying asset determines the value of the contract, allowing traders to take either short or long positions, depending on the circumstances. Also, the Pattern Day Trading rule (often called the PDT) does not apply to futures traders, removing the $25,000 margin account minimum.

Can futures prices predict the market?

Not exactly, but futures can be an indicator of certain market movements. Owing to the global nature of today’s markets, there may be market activity overseas that could impact U.S. markets — but many investors wouldn’t know for certain until the U.S. stock market opened. Owing to that lag, some investors look to futures — which trade virtually 24/7 — to gauge possible market trends.

Are there futures in cryptocurrency trading?

Yes. Cryptocurrency futures operate much the same as other types of futures contracts. Traders agree to buy (or sell) a contract tied to an underlying cryptocurrency for a specified price on an agreed-upon date in the future.

The Takeaway

Futures contracts allow traders to enter into a contract to buy or sell an underlying asset for a specific price at a future date. Futures trading offers investors the opportunity to hedge against the risk of price changes of certain assets and commodities, or to use futures contracts to speculate and potentially profit from those price movements.

Because futures contracts are generally liquid, they can be bought and sold up until the expiration date, which is a valuable feature for traders who don’t own or intend to own the physical asset.

Unlike trading most securities, the futures market is active nearly 24 hours a day, six days a week, allowing futures traders more opportunity and flexibility. But trading futures is not without risks. Because futures traders use leverage, that can allow them to place bigger bets on asset price movements, which can amplify gains but exacerbate losses.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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