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What Are Futures And Should You Invest In Them?

Andrew Dehan7-minute read
March 23, 2022

If you’ve ever wondered about the impact of events on the stock market, chances are you were thinking about futures, whether you knew it or not. Futures can affect the price of commodities, such as food, water, oil and textiles. They’re part of the toolset used by experienced investors to speculate on what will happen with specific assets over time.

But what are futures? How do they work? And should you invest in them? We’ll address all these questions and more in this article. If you’re curious about futures investing, speak with a financial advisor before investing.

What Are Futures?

Derivative futures contracts, or simply state, futures, are contracts between sellers and buyers agreeing to buy an asset at a set price on a future date. These contracts are used to avoid risk in price fluctuations, and in terms of commodities, secure future business.

Let’s outline a simple, fictional example. Say you’re in the business of manufacturing cotton T-shirts. You’ve signed a futures contract that you’ll pay $0.75 per pound of cotton for next year’s crop. You’ve locked in your cotton contract and can budget accordingly.

Then there’s a fire that destroys 15% of the cotton crop, sending cotton prices soaring. You’re still paying $0.75 per pound, due to your contract. The opposite is true, too. If the market is flooded with cotton, driving the price down to $0.60 per pound, you’re still paying what you agreed to in the contract.

What’s The Difference Between Options Vs Futures?

Options contracts and futures are similar in that they involve buying or selling an asset in the future. The difference is that options contracts give investors the right to buy or sell an asset at a certain price. Futures contracts are more specific. They require the buyer to purchase the asset from the seller at the set price by the set date.

Initially, institutional buyers were the ones who invested in futures, buying commodities like oil to sell to refineries. But the market is different now, with speculative investors trading the actual contracts. Speculative investors avoid taking delivery of the assets by selling their contracts, either at a profit or a loss.

How Do Futures Work?

Futures work differently than stocks, but they are tied to them. With futures, you don’t own a stock and you can’t collect dividends. Like the cotton example above, futures contracts are traded on stocks.

When talking about futures, you may hear the terms “long” and “short.” These are two strategies of profiting from stock futures. Going long on a stock with a futures contract means you expect the price of the stock to rise. Shorting a stock is a way to profit off of a stock you expect to drop in price.

Say you buy a futures contract that says in 2 months you’ll buy 50 shares of a company at $20 per share, totaling $1,000. In those 2 months, the price of the stock rose to $22 per share. This means you can sell your futures contract for $1,100, profiting $100.

Shorting stock is more of a gamble than going long. If an investor is short selling, they expect the stock’s price to fall. To short sell, you borrow shares from a broker and sell them on the market. If the price falls, you buy back the shares you sold at the new lower price, closing your position and collecting a profit.

However, if the price rises and you close your position, you will have to pay out the difference in what is referred to as “buying-to-cover.” This is what makes shorting stock a gamble. You will eventually have to close your position and may do it at a significant loss.

Who Buys Futures?

Both investors and producers buy futures. While retail investors may trade futures contracts on stock, producers are signing futures contracts to keep their businesses running.

Hedge Investors

Hedges are investments made with the idea of reducing risk. These include futures contracts. Companies that require a particular input for production can buy their supply on the futures market and hedge against inflation and wavering prices. Unlike speculative or retail investors, hedge investors intend to take delivery of the product they’ve contracted to buy.

For example, an oil refinery may agree to a futures contract with a seller of crude oil. They fully intend to receive the crude oil to process it. This contract will strike what’s determined as a fair price between the refinery and the crude oil supplier. The refinery gets the oil they need and the supplier profits enough to keep producing.

Speculative Investors

Speculative investors have strong opinions about the direction prices are headed in particular markets. They invest in futures to try to capitalize on their prediction. They deal mostly in contracts. If investing in commodity futures, they have no intention of taking delivery of the commodity. They will sell the contract before that happens.

This is a riskier type of investing than putting money in a mutual fund. Successful speculative investors can determine their margin for risk and wager their money. They may lose money on predictions, but if they have enough gains in other predictions, they’ll have a net profit.

What Markets Are Futures Linked To?

The futures market originally developed from commodities markets but has expanded. Now when talking about futures, these markets can be included:

  • Commodity futures such as in crude oil, natural gas, corn and wheat
  • Stock index futures such as the S&P 500 Index
  • Currency futures including those for the euro and the British pound
  • Precious metal futures for gold and silver
  • S. Treasury futures for bonds and other products.

How Are Futures Regulated?

Commodity futures contracts are regulated by the federal agency known as the Commodity Futures Trading Commission (CFTC). The futures marketplaces must comply with CFTC regulations. They surveil the market, setting limits on price fluctuations and overseeing how brokers handle investor money, among other things.

Along with regulating trade on commodities futures, they regulate trade on other financial instruments. This includes trading in other countries’ currencies. Currently, whether the CFTC has jurisdiction over vast digital and cryptocurrency markets remains somewhat of a legal gray area. The CFTC has won a few lawsuits where judges sided with them, but Congress has yet to legislate cryptocurrencies into the CFTC’s role.

What Terms Are Contained In A Futures Contract?

Futures contracts are standardized by the futures market and contain specific applicable terms. Here are some of the common terms you can expect to see:

  • Contract size: How much the contract is for. For instance, how many bushels of corn or barrels of oil.
  • Deliverable grade: Specific characteristics of what you’re buying. For instance, if you’re buying a corn futures contract, this may outline corn varietals or quality.
  • Pricing unit: The unit being used to trade, such as pounds, barrels or bushels.
  • Tick size: The minimum amount a price will fluctuate.
  • Last trade date: The last day you can sell the contract.
  • Last delivery date: The last day the deliverables will be delivered by.
  • Product ticker symbols: The symbols used for this product in the markets it’s being traded in.

The details of a futures contract may look something like this:

Sample Futures Contract

Risks Of Futures Trading

For investors who have no interest in receiving contract deliverables, and are just looking to profit off the speculative aspects of futures trading, there is plenty of risk. If you’re not an experienced investor and do not know how to research these markets, it’s best to avoid trading in futures.

Margin And Leverage

Futures contracts are purchased on margin, or debt. This means investors will buy huge contracts with 5% – 10% down. When that contract comes due, they will owe the rest payment.

Institutional investors, like hedge funds, never intend to collect on the contract. Instead, they predict that the price of the commodity will rise. This concept is called leverage. They then use their large purchase of this commodity to try to control the market. Before the contract is up, they will sell it. If they’ve succeeded, they will then profit from this sale.

If they predict wrongly, however, they’ll have to sell their contract at a loss.

Incorrect Predictions

The biggest risk of futures investing is that no one can predict with certainty what will happen in the future. A freak monsoon could destroy a crop, driving prices up, or a group on the internet could like a stock so much it drives the price up, causing the hedge fund who shorted the stock to lose lots of money.

Incorrect predictions can put you in major debt, which is why futures trading must be done carefully with full awareness of the risk.

How Can I Get Started On Futures Investing?

Many online brokerages offer the ability to trade in futures. People looking to open futures accounts will be asked about their experiences with investing, net worth and salary.

This is done to discourage new, inexperienced investors from taking on this type of investment. Since futures trading involves margins, or debt, the brokerage may want to vet investors before offering them futures trading services.

Look Before You Leap

Futures are contracts dealing in things like commodities and financial instruments. They’re sophisticated investment vehicles not meant for everyone. Many companies use futures contracts to fulfill their company needs for input, but large investors trade futures contracts on speculation that prices will rise or fall.

Should you invest in futures? If this is the first article you’re reading about futures, probably not. Do your research. Read more about the markets and follow them. Speak with a qualified financial advisor before making any changes or decisions. When you reach the point where you think you’re ready to invest in futures, make sure you have plenty of collateral. If you lose money, you want to be able to cover it.

Head to our Learning Center to learn more about investing.

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    Andrew Dehan

    Andrew Dehan is a professional writer who writes about real estate and homeownership. He is also a published poet, musician and nature-lover. He lives in metro Detroit with his wife, daughter and dogs.