Futures contracts, often simply called “futures,” are a type of contract in which an investor agrees to either buy or sell a specific number of assets at a fixed price on or before the date that the contract expires. Investors commonly use futures as speculative plays to attempt to profit from the price movement of the underlying asset. Are you thinking about investing in futures — or just learning more about these investments? Join us for a breakdown of futures, including what they are, how they work, and the advantages and disadvantages of trading them.
What Is a Futures Contract?
A futures contract is a type of derivative contract, which means that the value of any given contract depends on the price movement of whatever the owner has agreed to buy or sell. Say, for instance, that a buyer has agreed to purchase 100 barrels of oil for $87 a barrel on or by June 1, 2022. If the first of June rolls around and the price of oil is at $91 a barrel, then the buyer has scored a bargain. If, however, the cost of oil has dropped to $82 a barrel, then the buyer would be required to overpay for the oil at $87 because that’s what they agreed to do in the contract.
You might also be wondering why anyone who has no use for 100 barrels of oil would enter into such an agreement in the first place. The answer usually comes down to one of two things. The first is that, when you buy a future, you can always sell it to a third party on or before the expiration date. In the example above, if the buyer had correctly guessed that the price of oil would rise, they would more or less find themselves with an oil coupon on their hands. So at any point before June, they could sell the contract for a profit to someone else.
The second thing to consider is that it’s not uncommon for futures contracts to be settled with cash payments instead of the actual exchange of assets. Going back to our example, say that the oil price had risen to $91 a barrel, and the seller found themselves forced to sell their oil at a discount. Rather than doing so, they could hang onto their 100 barrels by instead paying out a cash settlement of $9,100. Thus, the buyer would still profit but wouldn’t have to figure out what to do with 100 random barrels of oil.
Futures contracts are available for trading various commodities, resources and assets. These are a few of the most popular:
- Financial Futures: Financial futures cover a wide range of financial assets ranging from individual stocks to entire stock indices, such as the S&P 500. They can also cover bonds and commodities and are usually honored through cash settlements.
- Currency Futures: Currency futures are a way to speculate on the exchange rates of various currencies, such as the Japanese yen.
- Energy Futures: Energy futures speculate on the price movement of energy commodities like gas or oil.
- Metal Futures: Metal futures revolve around the price fluctuations of everything from gold and silver to platinum and copper.
- Grain and Livestock Futures: Grain futures allow investors to speculate on the prices of crops like corn, soybeans and wheat. Livestock futures, meanwhile, involve animals like cattle or pigs.
- Food and Fiber Futures: Food and fiber futures cover contracts on products like coffee, cotton and sugar.
Futures vs. Options Trading
While both futures and options are common trading tools that allow investors to speculate on future price movements of certain assets, there are significant differences between the two that are vital to understand.
Options contracts give buyers the right but not the obligation to buy or sell a specified asset at a set price (known as a strike price) on or before a specific date. The buyer has to pay a premium to purchase the contract, but they don’t have to fulfill the contract’s terms if it turns out to be a bad deal. Hence, they have an “option.” They may lose the premium they paid for the contract, but it will often be far less than the loss they would have taken if they actually went through with the deal.
Futures, however, are a different story. Whenever the expiration date of a futures contract rolls around, the buyer is legally bound to honor the agreement outlined in the contract, whether with a cash settlement or the physical exchange of goods. The only exception is if the investor has managed to sell the contract to another party before the expiration date, thus freeing themselves from the obligation.
The Advantages and Disadvantages of Futures Trading
Whether or not trading futures is for you will highly depend on your level of risk tolerance. If you end up on the winning side of a futures contract, you can make a great deal of money quickly. If, however, your bet turns out to be wrong, you can lose just as much money just as fast.
This is especially true if you intend to trade futures on margin. Depending on your broker and their margin terms, you may only have to put up an initial 5–10% of the contract’s value. For instance, if you wanted to purchase a future worth $200,000, you might only have to put up an initial 5% of the value of the contract, or $10,000. If the trade went your way, you could make a bigger amount of money on a lower initial investment.
Unfortunately, the reverse is also true. Margin trading is, at its most basic, a process of borrowing money from your broker to make a trade. If the trade doesn’t pay out the way you hope, you’re on the hook to return the initial investment plus the cost of any losses you may have incurred. In essence, futures trading can be a bit of a double-edged sword in that it tends to be a risky business with the potential for high rewards and losses. Due to the risks involved, it’s highly advisable that you learn the ropes on a futures trading simulator so you can sharpen your skills without actually risking any real money until you’re ready.