A specific commodity asset or security will be purchased or sold under a futures contract at a specified price and future date. Futures exchanges like the CME Group are where futures contracts, or simply “futures,” are traded. To trade futures, a brokerage account must be approved.
Similar to an options deal, a futures contract involves both a buyer and a seller. When a futures contract expires, the buyer is required to purchase and receive the underlying asset, and the seller of the futures contract is required to provide and deliver the underlying asset, unlike options, which may become worthless at expiration.
A futures market is an exchange where investors can buy and sell futures contracts. In typical futures contracts, one party agrees to buy a given quantity of securities or a commodity and take delivery on a certain date. The selling party agrees to provide it.
Most participants in the futures markets are consumers, or commercial or institutional commodities producers, according to the Commodity Futures Trading Commission. Commodity futures and options must be traded through an exchange by people and firms registered with the CFTC.
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:
- An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.
- A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices.
- Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.
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 futures 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.
Futures are most frequently used by individual investors and traders to make predictions about how the price of the underlying asset will change in the future. By speculating on the future direction of the market for a certain commodity, index, or financial product, they hope to make money. Additionally, some investors utilise futures as a hedge, usually to lessen the impact of potential future market changes in a particular commodity on their portfolio or company.
Naturally, using stocks or ETFs in a similar way to speculate on or protect against future market movements. Although each has risks that you should be aware of, there are some clear advantages that the futures market can provide that the equity market cannot.
Establishing an equity position in a margin account requires you to pay 50% or more of its full value. With futures, the required initial margin amount is typically set between 3-10% of the underlying contract value. That leverage gives you the potential to generate larger returns relative to the amount of money invested, but it also puts you at risk of losing more than your original investment.
Futures provide a few ways to diversify your investing in ways stocks and ETFs can’t. They can give you direct market exposure to underlying commodity assets vs. secondary market products like stocks. Additionally, they allow you to access specific assets that aren’t typically found in other markets. Futures might also be used if you are looking for strategies designed to help manage some risk surrounding upcoming events that could move the markets.
With futures, the margin requirement is the same for long and short positions, enabling a bearish stance or position reversal without additional margin requirements.
Futures can provide a potential tax benefit compared to other short-term trading markets. That’s because profitable futures trades are taxed on a 60/40 basis: 60% of profits are taxed as long-term capital gains and 40% as ordinary income. Compare that to stock trading, where profits on stocks held less than a year are taxed 100% as ordinary income.
Futures contracts are typically traded on a stock exchange, which sets the standards for each contract. Since the contracts are standardized, they can be freely exchanged between investors. This provides the necessary liquidity to make sure speculators don’t end up taking physical delivery of a tanker-load of oil.
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Each contract is for a standard amount of the underlying asset. For example, gold futures trade in contracts for 100 troy ounces. So, if gold is trading for about $2,000 per ounce, each futures contract is $200,000 in value. Oil is measured in barrels, which are about 42 gallons, and each futures contract is for 100 barrels. Corn is measured in bushels, which weigh approximately 56 pounds, and futures contracts are standardized to 5,000 bushels.
Futures contracts also dictate how the trade will be settled between the two parties on the contract. Will the contract holder take physical delivery of the underlying asset, or will it provide a cash settlement for the difference between the contracted price and market price at the time of expiration?
With standardized futures contracts, it’s easy for investors to speculate on the future value of any asset traded on the futures market. If a speculator thinks the price of oil will spike over the next few months, they can buy a futures contract for three months or more from the current date. When the contract is close to the exercise date, they can easily sell the contract, hopefully for a gain.
Some parties use futures contracts to hedge their positions. A producer can use futures contracts to lock in a price for their goods. For example, an oil company might want to ensure it gets a specified price on its output for the year and sell oil futures to interested investors.
On the other side, a company might hedge the market for commodities they consume. For example, an airline may buy futures for jet fuel. That provides predictable expenses even if the price of jet fuel fluctuates.
Another way to hedge using futures is if you own a broad and diversified portfolio of stocks and want to protect yourself against downside risk. You could sell a futures contract for a stock index. The position would increase in value if the stock market went down.
Advantages and Disadvantages of Trading Futures
- Easy to bet against the underlying asset. Selling a futures contract can be easier than short-selling stocks, and you’ll gain access to a wider variety of assets.
- Simple pricing. Futures prices are based on the current spot price and adjusted for the risk-free rate of return until expiration and the cost to physically store commodities that will be physically delivered to the buyer.
- Liquidity. Futures markets are highly liquid, making it easy for investors to move in and out of positions without high transaction costs.
- Leverage. Futures trading can provide greater leverage than a standard stock brokerage account. You might only get 2:1 leverage from a stockbroker, but with futures, you could get 20:1 leverage. Of course, with greater leverage comes greater risk.
- An easy way to hedge positions. A strategic futures position can protect your business or investment portfolio against downside risk.
- Sensitivity to price fluctuation. If your position moves against you, you may have to provide more cash to cover the maintenance margin and prevent your broker from closing your position. And when you use a lot of leverage, the underlying asset doesn’t have to move very much to force you to put up more money. That can turn a potential big winner into a mediocre trade at best.
- No control over the future. Futures traders also hold the risk that the future isn’t predictable. For example, if you’re a farmer and agree to sell corn in the fall, but then a natural disaster wipes out your crop, you’re going to have to buy an offsetting contract. And if a natural disaster wiped out your crop, you’re probably not the only one, and the price of corn likely climbed much higher, resulting in a substantial loss on top of the fact that you don’t have any corn to sell. Likewise, speculators are unable to foresee all potential impacts on supply and demand.
- Expiration. Futures contracts come with an expiration date. Even if you would have been right on your speculative call that gold prices will go up, you might end up with a bad trade if the contract expires before that point.
How to Trade Futures
Getting started trading futures requires you to open a new account with a broker that supports the markets you want to trade. Many online stock brokers also offer futures trading.
To gain access to futures markets, though, they may ask more in-depth questions than when you opened a standard stock brokerage account. Questions may include how much money you need to start futures trading, details about your investing experience, income, and net worth, all designed to help the broker determine the amount of leverage they’re willing to allow. Futures contracts can be bought with very high leverage if the broker deems it appropriate.
Fees vary from broker to broker for buying and selling futures. Be sure to ask around to find the broker that works best for you based on price and services.
Once your account is open, you can select the futures contract you’d like to buy or sell. For example, if you want to bet on the price of gold climbing by the end of the year, you could buy the December gold futures contract.
Your broker will determine your initial margin for the contract, which is usually a percentage of the contracted value you need to provide in cash. If the value of the contract is $180,000 and the initial margin is 10%, you’ll need to provide $18,000 in cash.
At the end of every trading day, your position is marked to market. That means the broker determines the value of the position and adds or deducts that amount in cash to your account. If the $180,000 contract fell to $179,000, you’d see $1,000 come out of your account.
If the equity in your position falls below the broker’s margin requirements, you’ll be required to bring more cash to the account to meet the maintenance margin.
To avoid taking physical delivery of the underlying asset, you will likely need to close your position before expiration. Some brokers have mechanisms in place to do this automatically if you want to hold your position until it expires.
Once you’ve made your first futures trade, you can rinse and repeat, hopefully with great success.
Futures have limited value to most retail investors. The value comes from being able to use more leverage with futures contracts, but leverage is a double-edged sword. Your gains are magnified, but so are your losses.
Futures could be useful, however, to invest in assets outside of standard stocks, bonds, and real estate investment trusts (REITs). Instead of buying an energy stock, for example, you could buy a futures contract for oil.
Alternatively, you can invest in an exchange-traded fund (ETF) that tracks the commodity’s value. While you might have to pay an expense ratio on the fund, it’ll save you from having to manage a futures position or qualify for a futures trading account.
While futures are a great tool for businesses and advanced investors, most retail investors are better off with a simple buy-and-hold strategy that doesn’t require a margin account.