The Basics of Futures Contracts
What Are Futures Contracts?
Futures contracts are derivative contracts that give investors the right to buy or sell an asset for a predetermined price and amount at a set future date.
A variety of asset classes can be used for futures contracts including individual stocks, ETFs, currencies or commodities.
Futures contracts can be used to hedge against price volatility risk or to speculate on the future price of one asset — or of the whole market.
What Are Derivatives?
Derivatives are a type of financial instrument that derive their value from an underlying asset. These contracts are set between two parties and can be traded either on an exchange or over the counter (OTC).
Types of Futures Contracts
Futures contracts are written for a variety of financial and commodity assets. This includes stock indices, currencies, natural resources such as crude oil and agricultural products such as soybeans. Some of the most commonly traded futures contracts include:
- Stock Index Futures: Some of the most popular futures markets to trade. Traders can use index futures to speculate on the price direction of the S&P 500, Nasdaq-100, the Dow, the VIX and Russell 2000.
- Forex Futures: When compared to spot forex, currency futures trading offers many advantages. From transparency on a regulated exchange to the absence of uncertain transaction costs.
- Commodity Futures: Maybe the most popular type of futures contract, commodity futures give investors direct exposure to many commodities that are not able to be directly traded on traditional exchanges. Common contracts include grain futures, metal futures, oil futures, livestock futures and fiber futures.
- Interest Rate Futures: Traders bet on future movement of interest rates and bond yields.
Understanding Futures Contracts
Futures contracts allow players to secure a specific price to protect against large price fluctuations. Futures are typically traded on an exchange such as the Chicago Mercantile Exchange (CME Group), where traders can be paired with one another as well as business owners in order to trade contracts.
Not every participant wants to exchange a product in the future. Some are futures investors or speculators, whose goal is to make money off of price changes in the contract itself.
For example, if the price of natural gas rises, the futures contract itself would also rise in value, and the owner of the contract could sell it for a higher price in the futures market.
These traders can buy and sell futures contracts without intending to take delivery of the underlying commodity. They are only in the market to bet on future price movements.
Futures contract trades can either have physical delivery or it can be cash-settled, depending on the exchange used.
- Physical delivery: In this case, the physical assets are delivered to the buyer on a specified delivery date.
- Cash Settlement: Using this method, the contract seller doesn’t deliver the underlying asset but transfers the net cash position.
What is a Futures Market?
The futures market takes place on exchanges where investors can buy and sell futures contracts. The market tends to stay relatively liquid thanks to the number of speculators, investors, hedgers and others buying and selling contracts daily.
Commodity futures and options contracts must be traded through secondary futures exchanges, managed by people and firms registered with the Commodity Futures Trading Commission (CFTC).
According to the CFTC, most participants are commercial or institutional commodities producers or speculative traders.
Uses for Futures Contracts
There are two main futures trading strategies businesses and investors use: speculation and hedging.
Futures for Speculation
Futures contracts tend to be highly liquid, meaning there are plenty of buyers and sellers trading every day, giving investors ample ability to buy and sell up to the time of expiration.
For individual investors who trade futures without the intention of receiving the underlying asset, their goal is to trade based on their opinion of the asset’s future price movements. Prior to the expiration date, these traders will buy or sell offsetting contracts so they have no obligation to an actual commodity.
This investment strategy allows traders to speculate on the direction of a security’s price, gaining more leveraged exposure to the commodity market.
Often, these are assets that do not trade directly on the stock exchange, meaning investors can expand their exposure with futures.
In practice, if a trader bought a futures contract for crude oil, for example, and the price for crude rose, that contract would trade above the original contract price. This trader could sell the contract for a higher price and take the profit.
The profit made would come in the form of a cash settlement in the investor’s brokerage account. No physical product would exchange hands.
On the other hand, if the asset price falls below the contract price prior to expiration, the trader risks losing more than their original investment.
Futures for Hedging
The original purpose of futures contracts was for companies to lock in a price to pay for the future delivery of an underlying commodity. Companies typically use futures contracts to hedge against future price fluctuations that could increase supply chain or operating costs.
Institutional investors use futures to hedge against the future price risk of a commodity they are invested in.
Those who use futures for hedging, namely companies that rely on the underlying commodity for its operations, will receive the asset at expiration for the set price.
Why Do Investors Trade Futures?
While many investors use futures for hedging, futures traders use the contracts to trade on speculation of future price movements. Their goal is to profit off this speculation of where the market is heading — either for a specific asset or the market as a whole.
Hedging and speculation are not unique to futures though, so what is known to make them special?
Equity positions held in a margin account tend to have a margin requirement of 50%. This means investors must put up half of the contract’s value upfront. This is the case for most standard options contracts.
For futures, they typically have an initial margin requirement of only 3-10%. This gives investors the possibility to generate much larger returns relative to their initial investment, as their initial investment consists of only a fraction of the total contract value.
While this is a massive benefit when the price of the asset rises, if the price falls, it puts the investor at much greater risk. In the same way you can earn much more than your initial investment, you can end up losing much more as well.
There is also a lower financial commitment regarding the entire margin account. A typical margin stock trading account requires at least a $25,000 balance to actively day trade. Futures trading typically requires no account minimums.
Futures can help with portfolio diversification in a couple of ways that traditional asset classes can’t.
First, they give investors direct market exposure to underlying commodity assets that traditional secondary market products can’t provide, such as natural gas.
Secondly, futures also provide access to specific assets that can’t usually be found on the secondary market, such as soybeans or even the weather.
Unlike equities, the margin requirement for both short and long positions is the same for futures contracts. This means you can establish a bearish position without additional margin requirements.
Potential Tax Benefits
There is a potential tax benefit for trading futures compared to other short-term trading markets.
Profitable futures trades are taxed on a 60/40 basis: 60% of profits are taxed as long-term capital gains and 40% as ordinary income. Whereas short-term equity trades are taxed completely as ordinary income.
Risks of Futures Trading
Leverage is inherent in futures trading. It refers to the ability to control a high-value contract with a much smaller investment using borrowed capital.
This boosts a trader’s buying power and allows traders to control large positions with minimal risk capital, one of the major benefits of futures trading.
While leverage is what makes futures trading so profitable, it’s important for traders to understand that more leverage means you have the potential to lose much more than your invested capital.
Leverage and margin rules are less stringent in the futures and commodities markets than for stock trading. A commodities broker may allow you to leverage 10:1 or even 20:1, much higher than you could obtain in an equity margins account.
The greater the leverage, the greater the gains, but also the greater the potential for loss. A 5% change in prices can cause an investor leveraged 10:1 to gain or lose 50% of their investment.
This volatility means that speculators need the discipline to avoid overexposing themselves to any more risk than they are willing to take on.
Regulation of Futures
In the US, the Commodity Futures Trading Commission (CFTC) regulates the futures and options markets.
The National Futures Association (NFA) is a self-regulatory organization designated by the CFTC to protect investors and ensure registered firms are meeting their regulatory responsibilities.
Futures exchanges are self-regulatory organizations (SROs), meaning they create and enforce the rules that protect market participants and promote integrity through the market.
The Bottom Line
In simple terms, futures contracts give the buyer the right to purchase a set amount of an asset for a set price before a set expiration date.
Futures and options trading can be found across a variety of markets, but they can carry a lot of risks and may be too complex for many beginners.
A variety of assets can be traded as futures, but they are most commonly used in commodity markets.
This article was written solely for informational and educational purposes and is not intended to be construed or interpreted as the basis of investment advice.