A futures contract is an agreement to buy or sell an asset at a future date at an agreed-upon price. All those funny goods you’ve seen people trade in the movies — orange juice, oil, pork bellies! — are futures contracts.
Futures contracts are standardized agreements that typically trade on an exchange. One party agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The selling party to the contract agrees to provide it.
The futures market can be used by many kinds of financial players, including investors and speculators as well as companies that actually want to take physical delivery of the commodity or supply it. To decide whether futures deserve a spot in your investment portfolio, consider the following:
Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel:
In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it’s the basis of their business. They use the futures market to manage their exposure to the risk of price changes.
But not everyone in the futures market wants to exchange a product in the future. These people are investors or speculators, who seek to make money off of price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they’re just in the market to wager on price movements.
With speculators, investors, hedgers and others buying and selling daily, there is a lively and relatively liquid market for these contracts.
Commodities represent a big part of the futures-trading world, but it’s not all about hogs, corn and soybeans. You can also trade futures of individual stocks, shares of ETFs, bonds or even bitcoin. Some traders like trading futures because they can take a substantial position (the amount invested) while putting up a relatively small amount of cash. That gives them greater potential for leverage than just owning the securities directly.
Most investors think about buying an asset anticipating that its price will go up in the future. But short-selling always investors to do the opposite — borrow money to bet an asset’s price will fall so they can buy later at a lower price.
One common application for futures relates to the U.S. stock market. Someone wanting to hedge exposure to stocks may short-sell a futures contract on the Standard & Poor’s 500. If stocks fall, he makes money on the short, balancing out his exposure to the index. Conversely, the same investor may feel confident in the future and buy a long contract – gaining a lot of upside if stocks move higher.
Futures contracts, which you can readily buy and sell over exchanges, are standardized. Each futures contract will typically specify all the different contract parameters:
If you plan to begin trading futures, be careful because you don’t want to have to take physical delivery. Most casual traders don’t want to be obligated to sign for receipt of a trainload of swine when the contract expires and then figure out what to do with it.