What Are Futures In The Stock Market? Definition And Examples

If you’ve ever wondered about the impact of events on the stock market, chances are you were thinking about futures, whether you knew it or not. Futures can affect the price of commodities, such as food, water, oil and textiles. They’re part of the tool set advanced investors use to speculate on what will happen with specific assets over time, but as with any investments, there are risks you should be aware of.

So, what are futures, how do they work, and should you invest in them? We’ll address these questions and more in this article. If you’re curious about futures investing, speak with a financial advisor before investing.

What Are Futures?

Futures contracts, also known as derivative futures, are pacts between sellers and buyers agreeing to buy an asset at a set price on a future date. These contracts are used to avoid risk in price fluctuations and, in terms of commodities, secure future business.

Futures Example

Let’s outline a simple, fictional example. Say you’re in the business of manufacturing cotton T-shirts. You’ve signed a futures contract that you’ll pay $0.75 per pound of cotton for next year’s crop. You’ve locked in your cotton contract and can budget accordingly.

Then there’s a fire that destroys 15% of the cotton crop, sending cotton prices soaring. You’re still paying $0.75 per pound, due to your contract. The opposite is true, too. If the market is flooded with cotton, driving the price down to $0.60 per pound, you’ll still pay what you agreed to in your contract.

How Do Futures Work?

Futures work differently than stocks, but they are tied to them.

When talking about futures, you may hear the terms “long” and “short.” These are two strategies of profiting from stock futures. Going long on a stock with a futures contract means you expect the price of the stock to rise. Shorting a stock is a way to profit off a stock you expect to drop in price.

Say you buy a futures contract that says in 2 months you’ll buy 50 shares of a company at $20 per share, totaling $1,000. In those 2 months, the price of the stock rose to $22 per share. This means you can sell your futures contract for $1,100 for the same 50 shares, profiting $100.

Shorting stock takes the opposite approach when you expect the stock’s price to fall. To short sell, you borrow shares from a broker and sell them on the market. If the price falls, you buy back the shares you sold at the new lower price, collecting a profit on the difference.

However, if the price rises and you close your position, you’ll have to pay out the difference in what’s referred to as “buying-to-cover.” This is what makes shorting stock a bit risky. You’ll eventually have to close your position and may do so at a significant loss.

Who Buys Futures?

Both investors and producers buy futures. While retail investors, meaning non-professional investors, may trade futures contracts on stock, producers are signing futures contracts to keep their businesses running.

Hedge Investors

Hedges are investments made with the goal of reducing risk. These include futures contracts. Companies that require a particular input for production can buy their supply on the futures market and hedge against inflation and wavering prices. Unlike speculative or retail investors, hedge investors intend to take delivery of the product or commodity they’ve contracted to buy.

For example, an oil refinery may agree to a futures contract with a seller of crude oil. They fully intend to receive the crude oil to process it. This contract will strike what’s determined as a fair price between the refinery and the crude oil supplier. The refinery gets the oil they need, and the supplier profits enough to keep producing.

Speculative Investors

Speculative investors have strong opinions about which direction prices are headed in particular markets. They invest in futures to capitalize on their prediction and deal mostly in contracts. If investing in commodity futures, they have no intention of taking a delivery of the commodity. They’ll sell the contract before that happens.

This is a riskier type of investing than putting money in a mutual fund or target-date fund, like you may have in your 401(k). Accordingly, successful speculative investors estimate their margin for risk and wager their money. They may lose money on predictions, but if they have enough gains in other predictions, they’ll still make a profit.

What Markets Are Futures Linked To?

The futures market originally developed from commodities markets but has since expanded. Now futures can also include markets such as:

●      More commodity futures, such as in crude oil, natural gas, corn and wheat

●      Stock index futures, 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 products

How Are Futures Regulated?

Commodity futures contracts are regulated by the federal agency known as the Commodity Futures Trading Commission (CFTC). The futures marketplaces must comply with CFTC regulations. They survey the market, setting limits on price fluctuations and overseeing how brokers handle investor money, among other things.

Along with regulating trade on commodities futures, they regulate trade on other financial instruments. This includes trading in other countries’ currencies.

What Terms Are Contained In A Futures Contract?

Futures contracts are standardized by the futures market and contain specific applicable terms. Here are some of the common terms you can expect to see:

●      Contract size: This is how much the contract is for – for instance, how many bushels of corn or barrels of oil.

●      Deliverable grade: These are the specific characteristics of what you’re buying. For instance, if you’re buying a corn futures contract, this may outline corn varietals or quality.

●      Pricing unit: This is the unit being used to trade, such as pounds, barrels or bushels.

●      Tick size: This is the minimum amount a price will fluctuate.

●      Last trade date: This is the last day you can sell the contract.

●      Last delivery date: This is the last day the deliverables will be delivered by.

●      Product ticker symbols: These symbols are used for a product in the markets it’s being traded in.

Futures Contract Example

The details of a futures contract may look something like this:

Examples of corn futures:

Benefits Of Futures Trading

There are several advantages experienced investors may enjoy when trading futures. Let’s take a look at some of the top reasons why futures trading can be beneficial:

●      Futures contracts can be used to help investors guess which direction the price of an asset is heading.

●      Companies can protect against adverse price movement by hedging the price of their products.

●      Investors with a broker may be required to put down only a small fraction of the contract amount instead of covering the entire amount.

Risks Of Futures Trading

For investors who have no interest in receiving contract deliverables, and are just looking to profit off the speculative aspects of futures trading, there’s plenty of risk. If you’re not an experienced investor and don’t know how to research these markets, it’s best to avoid trading in futures.

Incorrect Predictions

The biggest risk of futures investing is that no one can predict – with certainty – what will happen to a commodity in the future. For example, a major weather event could destroy a crop, driving prices up. On the flip side, changes in demand can decrease prices on a specific commodity. Incorrect predictions can put you in major debt, which is why futures trading must be done carefully with full awareness of the risk.

What’s The Difference Between Options Vs. Futures?

Options contracts and futures are similar because they both involve buying or selling an asset in the future. The difference is that options contracts give investors the right to buy or sell an asset at a certain price. Futures contracts are more specific. They require the buyer to purchase an asset from the seller at the set price by a specific date.

Initially, only institutional buyers invested in futures, buying commodities like oil to sell to refineries. But the market is different now, with speculative investors trading the actual contracts. Speculative investors avoid taking delivery of the assets by selling their contracts, either at a profit or a loss.

How Can You Get Started On Futures Investing?

Many online brokerages offer the ability to trade in futures. People looking to open futures accounts will be asked about their experiences with investing, their net worth and their salary. This is to discourage new, inexperienced investors from taking on this type of investment. Since futures trading involves margins, or debt, the brokerage may want to vet investors before offering them futures trading services.

The Bottom Line On Futures: Look Before You Leap

Futures contracts deal with things like commodities and financial instruments. They’re sophisticated investment vehicles not meant for everyone. Many companies use futures contracts to fulfill their company needs for input, but large investors trade futures contracts on speculation that prices will rise or fall.

Should you invest in futures? Regardless of your decision, it’s important to do your research. We recommend speaking with a qualified financial advisor before making any changes or decisions. When you reach the point where you think you’re ready to invest in futures, make sure you have plenty of collateral. If you lose money, you want to be able to cover it.

Before you start growing your investment profile, it’s important to make sure the rest of your finances are in good health. Rocket Money^SM can help you by canceling unwanted subscriptions, monitoring your net worth, and more. To get started, sign up for the Rocket Money app today.