What Are Futures?
Stock market futures are financial agreements that obligate parties to buy or sell an asset at a predetermined date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, whatever the market price, at the expiration date. Futures traded on exchanges like the Chicago Mercantile Exchange can have underlying "assets" ranging from physical commodities to bonds to events like changes in index prices and weather events. This article focuses on futures whose underlying assets are securities in the stock market. These contracts are based on the future value of an individual company's shares or a stock market index like the S&P 500, Dow Jones Industrial Average, or Nasdaq.
Key Takeaways
- Futures are derivatives, which are financial contracts whose value comes from changes in the price of the underlying asset.
- Stock market futures obligate the buyer to purchase or the seller to sell a stock or set of stocks at a predetermined future date and set price.
- They are used to hedge the price moves of a company's shares, a set of stocks, or an index to help prevent losses from unfavorable price changes.
- Speculators trade futures not to hedge but to profit from expected changes in the price of a stock or index.
- Futures contracts trade on a futures exchange, and a contract's price settles after the end of every trading session.
Understanding Stock Market Futures
Futures contracts allow you to lock in the price of the underlying asset. These contracts have expiration dates and set prices that are known upfront. Stock futures have specific expiration dates and are organized by month.
Futures contracts have standard expiration months, though the exact options depend on the contract itself. Typically, there's a quarterly expiration cycle. For example, futures for a major index like the S&P 500 might have contracts expiring in March, June, September, and December. The contract with the nearest expiration date is known as the "front-month" contract, which often has the most trading activity. As a contract nears expiration, traders who want to maintain a position typically roll over their position to the next available contract month. The expiry is important because it influences trading strategies and liquidity. Short-term traders often work with front-month contracts, while long-term investors might look further out.
There are many types of underlying assets at issue in futures contracts, including the following:
- Commodity futures with underlying commodities such as crude oil, natural gas, corn, and wheat
- Cryptocurrency futures, which are based on moves in Bitcoin, Ethereum, etc.
- Currency futures, including those for the euro and the British pound
- Energy futures, with underlying assets that include crude oil, natural gas, gasoline, and heating oil.
- Equities futures, which are based on stocks and groups of stocks traded in the market
- Interest rate futures, which speculate or hedge Treasurys and others bonds against future changes in interest rates
- Precious metal futures for gold and silver
- Stock index futures with underlying assets such as the S&P 500 Index
It's important to note the distinction between options and futures. American-style options give the holder the right (but not the obligation) to buy or sell the underlying asset any time before the expiration date of the contract. With European options, you can only exercise at expiration but do not have to do so.
The buyer of a futures contract, meanwhile, must take possession of the underlying stocks or shares in an index (or the financial equivalent) at the time of expiration and not before. Buyers of futures contracts can sell their positions at any time before expiration and be free of their obligation.
How Futures Contracts Work
Futures contracts bind the buyer to purchasing and the other party to selling a stock or shares in an index at a previously fixed date and price. These agreements are standardized by quantity, quality, and delivery of the asset, making trading them on futures exchanges possible. Forward contracts, which existed before futures, are one-on-one agreements that work like futures but aren't guaranteed by an exchange's clearinghouse and can be adjusted according to the needs of those trading. The standardization of futures, meanwhile, helps ensure market transparency, enhances liquidity, and aids in accurate prices.
The terms of a futures contract include the type of asset (the stock or other financial instruments involved), the quantity of the asset, the agreed-upon price, and the delivery date. This information allows traders to gauge the risk and potential return, aiding investment decisions.
For example, suppose you think the S&P 500 index, which represents the stock price performance of 500 large companies listed on stock exchanges in the U.S., will rise in the next six months. You decide to buy a futures contract on the S&P 500 index, thus agreeing to purchase shares in the index at a set price at a future date, say, six months from now. If the index goes up, the value of the futures contract will increase, and you can sell the contract at a profit before the expiration date. Conversely, if the index falls, you would face a loss unless you are using the contract to hedge against a portfolio of stocks you own or roll over the contract, hoping for a change in fortune.
Selling futures works the other way around. If you believe a specific equity is due for a fall and you sell a futures contract, and if the market declines as expected, you can buy back the contract at a lower price, profiting from the difference.
When settling a futures contract, the method—whether by physical delivery of the underlying asset or cash settlement—depends on the asset. For futures contracts based on commodities like oil, gold, or wheat, physical delivery is standard. However, for futures contracts based on stocks and stock indexes, settlement is typically in cash rather than by physical delivery of the financial instrument. This is because it's more practical and efficient to settle these types of contracts in cash, reflecting the difference between the contract price and the market price at the time of settlement.
Futures and Leverage
Futures trading usually involves leverage. With futures, you often don't need to put up 100% of the contract's value when entering a trade. Instead, the broker would require an initial margin, a fraction of the total contract value.
The amount required by the broker for a margin account can vary depending on the size of the futures contract, the creditworthiness of the investor, and the broker's terms and conditions.
Futures for Speculation
A futures contract allows a trader to speculate on the direction of a commodity's price. If a trader buys a futures contract and the price of the commodity ends up above the original contract price at expiration, then there would be a profit. Before expiration, the futures contract—the long position—would be sold at the current price, closing the long position.
When the underlying assets are equities or indexes, the difference between the prices would be cash-settled in the investor's brokerage account, and no physical product would change hands. However, the trader could also lose if the commodity's price was lower than the purchase price specified in the futures contract.
Example of Speculating with Futures
Suppose you are interested in trading futures contracts on the S&P 500. The index is at 5,000 points, and the futures contract for delivery in three months is priced the same. Each contract is $50 times the index level, so one contract is worth $250k (5,000 points × $50). In a traditional investment scenario without leverage, to buy $250k worth of the S&P 500 stocks outright, you would need that amount of capital upfront. In futures trading, you only need to post a margin, which is a fraction of the contract's total value. Let's say the required initial margin is 10% of the contract's value. Therefore, you need to deposit only $25,000 (10% of $250,000) to enter into the futures contract.
Investors can also take a short speculative position if they predict the price of the underlying asset will fall. If the price does decline, the trader will take an offsetting position to close the contract. The net difference would be settled at the expiration of the contract. An investor would realize a gain if the underlying asset's price was below the contract price and a loss if the current price was above the contract price.
It's important to note that trading on margin allows for a much larger position than the amount held by the brokerage account. As a result, margin investing can amplify gains, but it can also magnify losses.
Going back to the example above, if the index falls by 10% to 4,500 points, the value of the futures contract would decrease to $225,000 (4500 points x $50). You would face a loss of $25,000, which equals a 100% loss on the initial margin. This example highlights the risk of using leverage in futures, as losses can also be magnified.
Trading Futures for Hedging
The majority of futures traded are used to hedge the price moves of the underlying assets. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges use (as in airlines and jet fuel) or produce (as in a gold mining firm and the metal) the underlying asset. Forward contracts—the precursors to futures—have been used for millennia by farmers worried that crops might drop in price by the time they are ready to harvest. Thus, they might use futures to lock in a specific price for selling their wheat. By doing so, they reduce their risk and guarantee they will receive a set price. If the price of wheat goes down, the farmer would have a gain on the hedge to offset losses from selling the corn at the market. With such a gain and loss offsetting each other, the hedging effectively locks in an acceptable price.
Example of Hedging with Futures
Here's how this would work when the underlying asset is a security or index in the stock market. Suppose a mutual fund manager oversees a portfolio valued at $100 million that tracks the S&P 500. Concerned about potential short-term market volatility because of upcoming economic data releases and geopolitical tensions, the fund manager decides to hedge the portfolio against a possible market downturn using S&P 500 futures contracts.
Let's say the S&P 500 is at 5,000 points. Each S&P 500 futures contract is based on the index times a multiplier, say, $250 per index point. Since the portfolio mirrors the S&P 500, let's do a direct hedge ratio of one-to-one. The value hedged by one futures contract would be 5,000 points × $250 = $1,250,000. To hedge a $100 million portfolio, the number of futures contracts needed is found by dividing the portfolio's value by the value hedged per contract: $100,000,000 / $1,250,000 = about 80. Thus, selling 80 futures contracts should effectively hedge the portfolio. Here are two possible outcomes:
- The S&P 500 index drops 10%, as the mutual fund manager feared. This brings it down to 4,500 points over the next three months, which means the portfolio would likely lose about 10% of its value, or $10 million, given it's closely mirroring the index. However, the futures contracts sold by the manager would gain in value, offsetting this loss. The gain per contract would be 5,000 - 4,500 points × $250 = $125,000. For 80 contracts, the total gain would be 80 × $125,000 = $10 million. This gain would effectively offset the portfolio's loss, protecting it from the downturn.
- The S&P 500 index, against expectations, goes up in value over the next three months. This means the portfolio's value would increase, but a loss in the futures position would offset this gain. This scenario is acceptable since the primary goal was to hedge against a downturn, ensuring the mutual fund and the retirement savings of many are protected.
Pros and Cons of Trading Futures Contracts
Pros
Potential speculation gains
Useful hedging features
Favorable to trade
Cons
Higher risk because of leverage
Missing out on price moves when hedging
Margin as a double-edged sword
Futures in stocks offer advantages and disadvantages that should be reviewed carefully before trading them. A major benefit of futures is your ability to leverage your investment. By only needing to deposit a fraction of the contract's total value (known as the margin) with your broker, you can significantly amplify your returns. This leverage allows for strong gains from relatively small price movements in the underlying asset.
Futures contracts can also serve as an essential tool for hedging against price volatility. Companies can plan their budgets and protect potential profits against adverse price changes.
However, futures contracts also have drawbacks. Investors risk losing more than the initial margin amount because of the leverage used in futures. If you're using futures to hedge against unfavorable changes in prices, you could miss out if the prices go up and the hedge proved unnecessary.
Regulation of Futures
The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market prices, including preventing abusive trading practices, fraud, and regulating brokerage firms engaged in futures trading.
Why Trade Futures Instead of Stocks?
Trading futures instead of stocks provides the advantage of high leverage, allowing investors to control large amounts of assets with a small amount of capital. This entails higher risks. Additionally, futures markets are almost always open, offering flexibility to trade outside traditional market hours and respond quickly to global events.
Which is More Profitable, Futures or Options?
The profitability of futures versus options depends largely on the investor's strategy and risk tolerance. Futures tend to provide higher leverage and can be more profitable when predictions are correct, but they also carry higher risks. Options, while potentially less profitable, offer the safety of a nonbinding contract, limiting potential losses.
What Happens if You Hold a Futures Contract Until Expiration?
When equities are the underlying asset, traders who hold futures contracts until expiration settle their positions in cash. In other words, the trader will simply pay or receive a cash settlement depending on whether the underlying asset increased or decreased during the investment holding period.
In some cases, however, futures contracts require physical delivery. In this scenario, the investor holding the contract until expiration would take delivery of the underlying asset.
The Bottom Line
As an investment tool, futures contracts offer the advantage of price speculation and risk mitigation against potential market downturns. However, they come with some drawbacks. Take a contrary position when hedging could lead to additional losses if market predictions are off. Also, the daily settlement of futures prices introduces volatility, with the investment's value changing significantly from one trading session to the next.
