What are futures? Definition, types, advantages and disadvantages
- Futures contracts are financial contracts that investors can use to speculate on the direction certain assets will take.
- Futures contracts can derive their value from many different types of assets such as commodities, currencies, stock indices and agricultural products.
- Investing in the futures market is considered highly speculative due to their low margin requirements and volatility.
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Much of the investing landscape is based on what an investor thinks about the economic landscape and the ways that investor can profit or protect themselves. If you believe in a business’s ability to be successful, perhaps you could buy the stock or a call option.
If you are pessimistic about the prospects for a business, you may want to consider put options. A futures contract is another financial tool that traders can use to speculate on fluctuations in the prices of assets like oil, gold, and other commodities.
But what exactly are futures contracts, how do they work, and what makes them different from options?
What are the futures?
Futures contracts are contracts in which the buyer agrees to buy a commodity or financial instrument in a quantity, price and date at a later time – and the seller agrees to sell or deliver the commodity. active. Futures contracts are derivatives, which means that their value is derived from an underlying asset. For example, a crude oil futures contract will be heavily influenced by price fluctuations in the oil market.
Futures contracts can be critical for businesses that depend on certain inputs to operate. The airline industry is well known for this, due to fluctuating jet fuel prices, and uses futures contracts to lock in prices and protect against unforeseen costs.
While futures contracts based on commodities like corn, oil, and wheat are the most common, there are several other types of assets that a futures contract can derive its value from. Here is a short list:
- Commodity futures contracts: Commodities are tangible assets, agricultural products and natural resources used in trade and commerce. A short list of futures in this category would include soybeans, corn, wheat, crude oil, and natural gas.
- Futures contracts on precious metals: Gold and silver are the most common metals that fall into this category. Investors who buy gold or silver futures are generally looking to protect themselves against global financial uncertainty, inflation, or geopolitical events.
- Futures on stock market indices: Futures contracts can also derive their value from an index such as the S&P 500, Nasdaq, Russell 2000 or Dow Jones. Investors use stock index futures to capitalize on anticipated movements of an index and may be sensitive to events such as the release of data, such as the US Jobs Report or Federal Reserve statements. .
- Forex contracts: These types of futures contracts can be based on exchange rates between countries. Some of the more popular currency futures include the Canadian dollar, British pound, Japanese yen, and euro.
- US Treasury Futures: Interest rates on Treasury bills have a significant impact on much of the financial markets. US Treasury futures allow investors to speculate on potential changes in interest rates.
Understanding how futures work
Each futures contract has five key elements, also known as standard contract specifications.
- Trading hours: Unlike the US stock market, which is open 9:30 a.m. to 4 p.m. ET, futures contracts trade almost 24 hours a day, six days a week, starting Sunday at 6 p.m. ET. The closing time varies between 5:00 p.m. and 6:45 p.m. ET on Fridays, depending on the type of contract you are negotiating.
- Contract size: Each type of contract has a predetermined size. A gold contract will always equal 1,000 troy ounces – a unit of measure used to weigh precious metals – while an S&P 500 futures contract will be $ 50 multiplied by the S&P 500 index. (So, for example, if the S&P 500 is trading at 2300, the contract value would be $ 115,000 [$50 x 2,300]).
- Contract value: The contract value is the current contract price. If gold is trading today at $ 1,500 an ounce, the contract value would be $ 150,000.
- Check mark size: This is the smallest denomination that a contract can fluctuate and varies depending on the type of contract.
- Delivery method: Futures contracts can be settled financially or physically. From an investor’s perspective, these are usually financially settled, while companies can choose physically settled contracts.
Futures contracts can be bought on margin, which means that an investor only needs to put in a small amount of money to control a much larger amount in the market. The minimum amount of money required to enter into a futures contract is known as the initial margin requirement.
These requirements are set by the futures exchange and are subject to change. Typically, the margin requirement for futures contracts is between 3% and 12%. This means that depending on the contract price, an investor could spend $ 5,000 of their own money to control a $ 100,000 investment, which is only 5%.
This amount of leverage can present serious risks if the investment does not go as planned and in some cases could cause an investor to lose more than the original amount invested.
Advantages and Disadvantages of Futures Contracts
As with any investment vehicle, there are pros and cons that you should be aware of. These are some of the main advantages and disadvantages.
Futures vs options
Futures contracts and stock options have many similarities – both are contracts between two parties and can allow an investor to hedge and protect their portfolio – but there are some key differences you should be aware of.
The financial report
Investing with futures can be a way to diversify your portfolio in a way that traditional investors in stocks and bonds cannot. This additional exposure comes with a few tradeoffs, including higher volatility rates, longer trading hours, and special tax benefits.
“Futures tend to be a more complex or advanced financial instrument,” adds Henderson. While the potential for large profits can be tempting, consider the risks carefully before you get into futures trading. It may also be a good idea to consult a certified financial planner to make sure that negative developments in the futures market do not threaten your overall financial security.