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Stocks are fairly easy to understand. When you buy shares of a public company, you’re buying a little stake of ownership in the business. Owning shares means you have equity in the firm, and you’re entitled to a portion of the company’s profits.
Futures are more complicated. Futures are a derivative of another underlying asset at a certain price in the future.
Still unsure about what futures are and what they can offer you? Learn more about futures now with Benzinga’s guide.
What Are Futures?
When you buy futures, you’re buying contracts that specify delivery of the underlying asset at a certain price at a future date. Futures contracts can be based on all kinds of assets: commodities like gold and oil, stocks and stock indices, bonds or currencies and cryptocurrencies.
Futures contracts entitle the owner to delivery of the underlying asset at the agreed-upon price at expiration of the contract. Futures are used by individual traders to speculate on different asset prices, but also by companies and institutions to mitigate risk if they’re exposed to the underlying asset.
How Do Futures Contracts Work?
Futures contracts are sold on exchanges like stocks and options. All contracts have a buyer and a seller. The seller agrees to deliver the asset while the buyer agrees to purchase at the price specified by the contract. The contract will be dated by the month, which is also known as the delivery date. The price of the agreement is known as the forward price.
Futures are purchased on margin, so the buyer only needs to produce a percentage of the capital required to open the position. For example, an oil futures contract might trade at $85 for the February 2022 delivery date. But this contract isn’t just for a single barrel of oil. Oil futures traded on the NYMEX exchange are for 1,000 barrels per contract, so a single contract is worth a position of $85,000 if the price is at $85.
But thanks to margin, the buyer doesn’t need to pony up the full amount just yet. Margin rates depend on the broker you use and the date of the contract you purchase, but you could open this $85,000 position with as little as $5,000 to $6,000.
To accept delivery, you’d need the full amount of the position. But what would you do with 1,000 barrels of oil? For the speculator, nothing. Speculators and traders of futures will sell the contract before the delivery date,or settle the agreement in cash if such an arrangement is permitted. Most futures contracts can be settled in cash, so you don’t need a warehouse to store your oil or gold should you be forced to take delivery.
Speculators aren’t the only investors who trade futures. Futures contracts can be excellent hedging instruments for companies exposed to the price of the underlying asset. Futures are used to “lock in” the price of a specific asset like oil or coffee so producers and distributors aren’t caught off guard by sudden price gyrations.
Capital consuming industries like oil and gas drillers often depend on futures contracts for stability in their business plans. For example, finding an oil patch, drilling the raw product, and refining the crude into usable oil can take months or even years to complete. What happens if oil is priced at $85 at the start of the operation but plunges to $55 by the time drilling is complete? Without futures contracts, the drillers would have a large gap on their balance sheet as the oil they spent months extracting is now worth 35% less than anticipated.
Futures contracts can be sold for a profit, or loss, at any time before the delivery date, which is how speculators make money from them. Buying or selling futures contracts is a ‘bet’ on the direction of an asset price without actually owning the asset in question.
Benefits of Futures Contracts
Futures contracts offer specific benefits to specific investors and entities. Here are a few of the pros to consider:
- Opportunities for speculators: While not the original intention of futures contracts, speculation on illiquid assets like gold and oil is much easier thanks to derivatives. Margin allows speculators to control large positions with relatively little capital and reap huge gains should their thesis prove correct.
- Security for certain industries: Understanding the futures market is a must for companies in industries like oil and gas, precious metals, and agriculture and livestock. These industries would be incredibly risky to enter if futures contracts couldn’t be used to lock in prices and unpredictability reigned supreme. Futures contracts allow these companies to mitigate risk and better provide the products we need.
- Outsized profits with margin: You may only need a 5 to 10% “down payment” on your position to open it. If you control a $100,000 position with only $10,000, you’ll still realize profits on the value of the investment. So if oil prices rise 30%, you earn 30% on that $100,000 position, not the $10,000 in actual capital you put up.
- Settle in cash: Futures exchanges know that most investors won’t be able to accept 1000 barrels of oil or 100 troy ounces of gold, so they take delivery of the asset and allow the investor to settle their agreement in cash. Unlike stock options, futures contract holders MUST accept delivery if held through expiration, but cash settlements prevent logistical headaches here.
Drawbacks of Futures Contracts
Of course, like any investment, futures contracts bring their own drawbacks. Here are a few of the cons associated with futures:
- Downside of leverage: Margin cuts both ways and outsized profits can easily become outsized losses if the trade goes sour. If you opened a $100,000 position in oil futures with $10,000 in capital and the price of oil gets cut in half, you’ll have lost $50,000 on your $10,000 investment. If your account drops below the broker’s maintenance margin level, you’ll need to fund your account with more capital.
- Unpredictable markets: Futures markets, especially commodities, are unpredictable and subject to many different macro and geopolitical issues. Plus, they trade 24 hours per day during the week, which adds stress not found in traditional equity markets that only open from 9:30 AM to 4:00 PM.
Compare Futures Brokers
Most major online brokers have reduced stock and ETF commissions to 0, but you’ll still pay a fee to trade derivatives like options and futures contracts. If you’re looking to trade futures contracts, you’ll need to pay close attention to the fee structure and margin rates.
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Futures Markets: Upside and Risk
Futures markets can be enticing since profits can be earned quickly and exchanges trade around the clock during the week. For many traders, futures are the first introduction into leveraged products and margin. However, not every trader has the mindset and temperament to trade these derivatives.
When leverage is applied, profits and losses are magnified and undisciplined traders could find themselves breaking their own rules in an attempt to recoup losses or keep the gain train going. Always have a plan when trading futures and know where your exit points are to the upside and downside.
Frequently Asked Questions
What is the difference between stocks and futures?
A stock is an asset that signifies an ownership claim in a publicly traded company. The stock price is the amount of compensation the owner would be entitled to should the company liquidate. A futures contract is a derivative based on the price of an underlying asset. Futures contracts aren’t issued by the owner of the underlying asset like a company issues stock. Instead, futures are agreements drawn up between 2 individual parties betting on the direction of a price of the underlying asset.
Why are futures so profitable?
Futures are profitable because if an investor has good judgment, they can m ake a lot of money quickly because they trade with 10 times as much exposure as those who trade normal stocks.