What Are Futures Contracts?

oil rig with cows

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Leverage, margin, cash settlement, physical delivery – futures trading has its fair share of jargon terms. But hang tight, the learning curve is not as steep as you might think at first and investors of all levels can benefit from futures trading, not least when managing portfolio risk.

Here are the basics of what futures are and why investors use future contracts.

What Is A Futures Contract?

A futures contract is an agreement to buy or sell an asset for a fixed price at a future date.

To easily understand futures, it is helpful to step into the shoes of a farmer in the middle of Iowa.

Like a wage-earning employee, the farmer wants a predictable income from his crop of land, but unlike a W-2 employee, who can count on a regular paycheck, the income the farmer earns is dependent on the whims of weather patterns.

One year the sun shines and the farmer makes a bunch of money and the next storms spoil the crop and the farmer earns a pittance.

By year three, he wants to smooth out the volatility in his income, so he doesn’t risk earning little after many months of hard work – even if it means locking in slightly lower prices for his crop.

But how does he do that?

Futures allow the farmer to lock in a price at which he can sell his wheat or barley. On the other side of the transaction is a buyer who doesn’t want to risk paying a premium in the event of a gangbuster year for crops.

So, both the farmer who agrees to sell his crops at a certain price and the buyer who is pleased to lock in a purchase price to avoid overpaying down the line come to an agreement to exchange a specific quantity of commodities for a certain price at some fixed point in the future. The agreement is called a futures contract.

And it applies to many industries beyond the world of farming. For example, an airline executive may not want to risk the price of oil spiking during summer months, which would lead to higher costs and lower margins.

By entering futures contracts to buy a fixed quantity of jet fuel within a certain time frame at a certain cost, the executive manages the risk of spiralling costs better than if he rolled the dice and hoped oil prices would not increase.

>> More: How To Hedge Using Options

How To Trade Futures Contracts?

Futures contracts are bought and sold by speculators looking to profit directly from movements in the price of futures contracts and investors looking to hedge.

Businesses, farmers and other commodities buyers and sellers generally transact in futures contracts as a means of hedging, so they can smooth out revenues or costs that might otherwise be spiky.

Another type of futures trader comes in the form of speculators, who buy and sell to make a profit rather than to take physical possession of a commodity or deliver physical goods to a futures buyer.

For the most part, futures contracts are highly liquid and heavily traded. When prices rise, speculators may be tempted to sell for a profit while a business may find value purchasing at higher prices today because it may save them from paying even more later.

Futures contracts can be issued on a wide variety of commodities, including:

  • Oil
  • Natural gas
  • Precious metals
  • Soybeans
  • Cotton
  • Lumber

Future contracts are not always traded on commodities. You can buy and sell futures on the general stock market, such as the S&P 500, as well as on bonds and individual stocks.

An investor who is bullish on the stock market may purchase an ETF on the S&P 500, or they could buy futures that allow them put up a relatively small amount of cash yet reap hefty rewards.

Equally, a bearish trader could short-sell futures contracts and make money from a decline in say the S&P 500.

>> Related: How To Short Sell Stock

What Is The Risk
Trading Futures Contracts?

Futures traders have access to much higher margin than do equities traders, so portfolio swings up and down are amplified.

LEVERAGE RISK

When investors open brokerage accounts, they usually invest their own cash, but they are permitted to borrow money to invest also.

Typically, account holders can borrow as much as double the amount they deposited, so a $100,000 cash deposit would allow an investor buy as much as $200,000 worth of stock, such as Facebook.

In some cases, when using portfolio margin, buying power of 4:1 is permitted. A $100,000 cash deposit into a brokerage account would then permit the investor to buy up to $400,000 worth of stock.

A great deal more leverage is at your fingertips when trading futures contracts. Buying power of 10:1 is available and even 20:1 on some futures contracts.

Using 10:1 leverage, a 3% move in the underlying commodity would result in a 30% gain or loss for the futures trader. So, you can see it is easy both to make a boatload of money and lose it too!

To manage risk, investors who own large equities portfolios will often hedge using futures contracts. For example, they might choose to short-sell S&P 500 futures contracts to protect their equities portfolio from downside risk.

>> Find Out How To Protect Your Equities Portfolio Trading Married Puts

DELIVERY RISK

Imagine your worst trading nightmare, what would it look like? Near the top of the list might be receiving a call saying that your delivery of live cattle has arrived.

“Wait, what?” you exclaim, “that can’t be!”

Believe it or not this is a real risk when trading futures. When contracts expire, you are obligated to take receipt of goods when you buy futures contracts, and delivery may indeed be a container of live cattle.

To avoid such an unfortunate circumstance – assuming a herd of live cattle is not something you want to transport – make sure to exit your futures contracts prior to contract expiration so you don’t have to worry about the hassle of moving goods from A to B.

What Is The Makeup Of Futures Contracts?

When you buy and sell futures contracts, it’s unlikely that you’ll end up in a situation where you need to take delivery of a container of pork bellies, for example, if you have spent a little time upfront analyzing your futures contract.

The makeup of your futures contract will involve:

  • Quantity of goods delivered or covered
  • Settlement terms, whether cash or delivery of physical goods
  • Currency quoted
  • Currency unit in which contract is denominated
  • Unit of measurement
  • Quality of good, such as purity of gold or grade of gasoline

Obviously, the settlement terms is one of the most important characteristics to pay attention to when trading futures. When you trade stock market futures, cash settlement is typical.

The unit of measurement is equally important because it provides insights into leverage, which will in turn affect swings in the value of your portfolio.

Compare Future Brokers

The best futures brokers will have fast and accurate order execution, competitive commissions costs, and top notch customer support. You may also want a suite of tools to analyze trading opportunities, including technical studies and overlays.

If you believe you can stomach the portfolio swings of futures trading, select a top notch broker who meets your needs.

If you are getting started, you might want better customer support than an experienced futures trader who may put more emphasis on low commissions costs.

No matter whether you are a beginner or have been around the proverbial trading block, fast and accurate order execution is the very least you should expect and demand of your broker or trading platform.

Beginner futures traders should abide by the rule that practice makes perfect. Get started using a paper trading or virtual trading demo account. The leverage involved in futures trading takes a little getting used to, especially if you have come from the world of stock trading.

When you feel comfortable to go live, some of the best futures trading platforms available these days include thinkorswim and TradeKing.

THINKORSWIM® SPOTLIGHT

thinkorswim®

InvestorMint Rating

5 out of 5 stars

  • Commissions: $6.95 per trade
  • Account Minimum: $0
  • Promotion: Trade free for 60 days, based on $3,000 deposit

via thinkorswim secure site

Have you traded futures in the past? What tips can you share about your futures trading experiences? Share your comments with us below, we would love to hear from you.

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