If you’re interested in the world of stocks and investing, you may have heard of stock futures. The stock market can be confusing, and stock futures are no different. Benzinga has put together this guide to help you understand the stock futures meaning and how it all works.
The easiest way to understand the stock futures definition is to take it very literally. Stock futures are contracts to buy or sell a stock for a certain price on a future date. Stock futures should not be confused with options. Stock futures have both buyers and sellers who must enter into an agreement with fixed prices and expiration dates.
Think of it as you would a small business transaction. Say you have a small baking business. You source some of your ingredients from a local farmer. The market rate of products fluctuates on a daily basis, right? So even though the price is good now, in 6 months the going rate for 50 pounds of butter might be much higher or lower.
To offer stability to both your business and the farmer, you could enter a contract for the future. In this contract, you agree to purchase the 50 pounds of butter from the farmer in 6 months for an agreed-upon price. This way, the farmer can guarantee the future sale and you can guarantee that you will get your product for a set price.
How Do Futures Work?
When you buy or sell a stock future, you enter into a stock future contract. This contract is an agreement to buy or sell the stock certificate at a fixed price on a specific future date. The contract will expire on the set future date.
Stock futures differ from a traditional stock purchase. When you purchase a stock future, you never own the stock. You can make money from stock futures even when the market goes down. This is not like traditional stock market investing where you only make money when your stock’s price is on the rise.
There are 2 stock futures positions:
- Long: A long position is an agreement to buy the stock when the contract expires. This is the position you’d want to take if you think that the price of the stock will be higher in 3 months than it is today.
- Short: A short position is an agreement to sell the stock when the contract expires. You’d take the short position if you think the stock price will be lower in 3 months than it is today.
When you buy or sell a futures contract, you only need to pay for a percentage of the contract’s price. Usually, you will pay from 10% to 20% of the price of the contract. In the investing world, this is called buying on margin.
So why do people invest in stock futures? Most investors who use stock futures do so as a part of their investment strategy. This is because investing in a single stock future as a standalone security can be a risky investment. Stock futures can be a valuable part of a complete investment strategy.
Here are some of the common strategies investors use when investing in stock futures:
- Hedging: Have you ever heard of hedging your bets? That’s exactly what hedging is in relation to investing. If you use this strategy, you will take both a long and short position on a specific stock. This provides security to the investor because even if the stock price goes down, you can make up at least some of the money on the futures market.
- Calendar spread: You can also use this strategy, which is similar to hedging. In a calendar spread, you will go both long and short on the same stock future. You will have 2 different contracts, each of which expire on a different date.
- Intermarket spread: This strategy again uses the method of going both long and short on stock futures. In an intermarket spread, you will go long on one stock future and short on another, instead of going long and short on the same stock future. To do this, you choose 2 different stock futures that are within a related market and purchase your stock futures for the same date. If one of these stock futures suffers a loss, the other might give you the reward of a gain because the stock futures are in the same market.
- Matched pair spread: This method is similar to an intermarket spread. You would enter a futures contract to buy shares in 2 companies that are direct competitors. For example, maybe you would buy stock futures in ExxonMobil and Chevron Corp. if you want to invest in the oil industry. Doing this will guarantee that you will break even on your investments.
- Speculating: The investment strategies above more or less lower the risk of investing in stock futures. On the other hand, speculating is a riskier strategy. Speculating is when you invest large amounts of money on margin. You would predict short-term movements within the stock market, invest your money on those stock futures, and hope to see a big return on your investment. This method aims to quickly cash in on fluctuations in the stock market.
Examples of a Futures Contract
Let’s break down the 2 different stock futures contracts.
If you take a long position, you’re going to be entering a stock futures contract to purchase shares. For example, let’s say at the start of the new year, you decided to enter into a futures contract. You decided that you want to purchase 100 shares of Apple stock at $50 per share. You decide that you will purchase this on April 15.
If the market value of the Apple stock goes up before your expiration date of April 15, you can sell the contract early to make a profit. Your futures contract has a price of $5,000 when you enter the contract. But if the price of Apple’s stock rises to $52 per share in March, you can sell your contract for $5,200.
If you take a short position, we can use the same example but flip it the other way around. The short position means that you’re selling your shares. So let’s say you enter in a futures contract to sell 100 shares of Apple at $50 per share on April 15. Again, your contract is worth $5,000.
But then in March, the value of Apple stock drops to $48 per share. At this point, you can buy the contract back. This means you will pay $4,800 for a contract that is worth $5,000. Since you predicted that the stock price would go down when you took the short position, you make a $200 profit.
Pros of Trading Futures
- It allows you to pay on margin, so you’re only putting down a small percentage of your contract price when you enter the stock futures contract.
- It offers some protection against price fluctuations.
- Trading futures can be a valuable part of a total investment strategy.
Cons of Trading Futures
- Trading futures can be risky.
- By entering in a contract for a fixed price, you may miss out on the benefits of major price movements.
How are Futures Regulated?
Believe it or not, there is a federal agency that was created solely to regulate the futures market. The Commodity Futures Trading Commission was created by Congress in 1974 to regulate the futures market. This agency ensures the integrity of the futures market pricing.
Any brokerage firms that engage in futures trading are regulated by the Commodity Futures Trading Commission. This helps ensure that any broker you work with is being held to the highest standards. This regulation prevents abusing trading practices and even fraud.
Best Futures Brokers
When you decide to invest in stock futures, you’ll want to do some research to find the best futures broker. Here are some things you may want to look for in your broker:
- Low commissions (you want to keep as much money as you can)
- Excellent customer service
- Top-notch charting and screening tools
- Intuitive trading platforms
Find a broker to help you as you begin and continue to offer the support you need after you’ve gained more experience. NinjaTrader is one of the top futures brokers for active traders. It offers low commissions and an extensive collection of technical analysis tools to help you get started. NinjaTrader also offers a free 2-week trial, so there’s no harm to check it out to see if the futures trading platform is right for you.
Final Things to Know About Futures Contracts
As with any type of investing, futures contracts can be risky. However, when you’re building your investment strategy, it’s important to consider all of your options. Futures, along with forex, are great ways to branch out and diversify your investments.