Introduction to Futures Contracts

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Contributor, Benzinga
January 18, 2023

If you are relatively new to trading and doing some research, you might hear the term “futures” or “futures contract” thrown around when discussing action in the market. Futures contracts are standardized contracts to buy or sell an asset, commodity or share in an index at a future date at a set price. Futures contracts can help you as an investor capitalize on future price movements based on speculative data. 

Introduction

A futures contract is a financial instrument that falls into the category of derivative contracts. Derivative contracts get their value from an underlying asset, index or interest rate. Futures, forwards, swaps and options all fall into the category of derivatives, but they each operate as independent assets.

In a futures contract, two parties agree on a transaction of a certain asset for a price set today, but with the transaction occurring at a specific time in the future. For example, a gold investor who believes that the price of precious metals will increase in the future might invest in a futures contract from a broker that agrees to sell the underlying asset (gold) at today’s price in a few months. 

If the price of gold goes up, the futures contract entitles the investor to purchase the defined amount of gold at the price it was previously. If the price remains the same or decreases, the investor can choose not to exercise the contract, allowing it to expire. 

Both futures contracts and forwards follow the same basic structure detailed above. Futures differ from forwards in that they are standardized contracts made via a futures exchange. The futures has its own regulatory body, the Commodity Futures Trading Agreement (CTFC), which was created by Congress to oversee the trades.

Futures are common in the commodity industry, and you are most likely to hear about a futures price when discussing oil. Oil is typically traded on the futures market, meaning the manufacturer and the buyer agree to transact the oil at a later date and agree on the price today. Miners, farmers and other manufacturers trade in futures so that they can sell their goods easily without the rapid fluctuations of the market.

Where to Invest in Futures

What are Futures Contracts?

Futures contracts are derivative agreements traded on an organized exchange to buy or sell assets, especially commodities or shares, at a fixed price but to be delivered and paid for later. While the example above used gold, investors can purchase futures contracts for a wide range of tangible assets, including livestock and edible commodities like sugar and grain. 

In the real world, futures are used for two main purposes: to speculate or hedge against price movements of the underlying asset. Speculators use futures to try to profit on a range of different assets, by guessing that they will rise or fall in a given period of time. 

If you feel the price will rise on oil, for example, you can purchase a futures contract tied to the price of oil. If oil goes up, so will the value of your futures contract, and you can sell your contract for a profit. In this scenario you are “going long,” meaning you think the price will rise. If you think the price will fall, you can place a sell order for a futures contract and “go short” until prices fall, at which point you can buy back the contract for a profit. 

The other major use of futures contracts is to hedge against losses in other investments. Hedging is used by investors but also by corporations and large companies that need to purchase a certain good in the future. 

If a company needs a raw material to produce a good, it can lock in a price using a futures contract, allowing it to hedge against price fluctuations of that good and successfully plan for future budgeting. The inverse is true as well. For example, let’s say a company is selling a specific product that requires raw materials to produce. It can agree to sell that item at a given price before it is produced by locking in material prices via futures contracts. This way, the company can begin fulfilling future orders without worrying about changes in supply chain pricing affecting its bottom line. 

Over the years, the assets in futures have changed significantly. In the 1970s, futures were almost exclusively used for agricultural goods, with some being made for precious metals. Over time, more and more assets like oil, traditional currencies, indices and even cryptocurrencies entered the futures market.

How Do Futures Contracts Work?

Futures are executed on a futures exchange and regulated by a clearing house. All futures contracts are standardized and regulated, and the clearing house bears the risk of default by either party. Buyers and sellers don’t have the added step of vetting the other side like they would in a forwards contract, making these trades easier to complete while still allowing both sides to agree on terms.

Margins are an important part of futures contracts. Margins are akin to deposits that you can use to trade with a higher value, as futures contracts typically require a major capital investment that you may not have immediate access to. Depending on what assets are being traded, brokers will require a certain percentage of the contract amount upfront before allowing you to trade. If the price fluctuates a great deal, it’s possible a larger percentage will be required as a maintenance or variation margin in addition to the initial margin.

Because margins are relatively low in comparison to the value of the futures contract, this gives the parties a great deal of leverage. They can increase their buying or selling power exponentially with a low-cost barrier to entry. Leverage is power in investing but also exposes investors to a great deal of risk if their investments do not pan out. If you are a new investor, limit your use of leverage as much as possible, especially when trading in the futures market. 

Types of Futures Contracts

Futures contracts can be purchased for a number of different underlying assets, and each of them has different features and benefits to investors.

  • Commodity futures: Commodity futures (agriculture, oil, etc.) were the most popular futures for decades and still are heavily traded on the futures exchange. Corporations are the main investors in these futures contracts, as they use locked-in prices to hedge against fluctuations in the market and guarantee either prices on goods or revenue from sales.
  • Financial futures: If investors have a feeling about currency exchange rates, interest rates or treasury rates, futures contracts can be made on these financial measurements as well.
  • Index futures: Investors can use leverage and trade on the sentiment of the market by taking on futures tied to major indexes like the S&P 500 or Dow Jones. 
  • Crypto futures: Combining the volatility of cryptocurrency and the leverage of futures, new Bitcoin futures allow for maximum exposure to profits and losses.

Benefits and Risks of Investing in Futures Contracts

For corporations, futures contracts are beneficial because they allow them to lock in profits or prices on their sales or purchases at a future date. For this reason, futures remain popular among many industries to this day. When individual investors buy any stock there is a component of speculation, but futures take that speculation to a new level by making buyers and sellers commit to a price at a date in the future.

Because this is the case, the benefit and risks of investing in futures lie on two ends of the same spectrum. Futures allow for investors to maximize profits from a minimal cash investment if they pick the correct side of the contract. Conversely, if the market fluctuates in a way that the investor did not anticipate, they might lose a very large sum compared to the initial margin. In short, leverage is the biggest benefit and the biggest risk in investing in futures. 

Learn More About Futures Contracts Today

Futures contracts have been an integral part of many stock portfolios for decades, and the ability to speculate and hedge using the stock market is a tool in the arsenal of an experienced stockbroker. While leveraging futures contracts can lead to great profit, it can also get investors into a bad situation. If you’re a new investor, be conservative with your leverage usage until you gain some experience in the market and develop a unique trading strategy. 

Frequently Asked Questions

Q

Are all futures contracts the same size or value?

A

No. All futures contracts range in value and duration. Plus, the underlying asset for every contract can be quite different depending on the industry in which it is typically used.

Q

Can you make money trading futures contracts?

A

Yes, you can make money trading futures contracts, but there is no guarantee that every futures contract will be profitable. Only invest money you are prepared to lose and research each contract with Benzinga before making a move.

Q

Can you keep futures contracts instead of selling them?

A

Yes, you can keep and take delivery of the underlying asset in a futures contract, but industry professionals are generally the only investors who take such a step.

About Sarah Horvath

Sarah is an expert in the insurance, investing for retirement and cryptocurrency space.