What are Futures in the Stock Market?
Futures are financial contracts that require parties to acquire or sell an asset at a fixed date and price. Regardless of the market price at expiration, the buyer or seller must acquire or sell the asset at the agreed price.
Assets include commodities and financial instruments. Futures contracts, standardized for trade on exchanges, describe the quantity of the underlying asset and are helpful for hedging or trading.
Understanding Futures in the Stock Market
Futures contracts enable merchants to secure the price of an underlying asset or commodity. These contracts have predetermined expiration dates and rates. The month of expiry identifies futures. Example: December gold futures expire in December.
Traders and investors call the asset class futures. There are several futures contracts to trade, including:
- Futures on crude oil, natural gas, corn, and wheat
- An S&P 500 Index-based stock index futures
- Euro and British pound futures
- Gold and silver futures
- US Treasury bond and financial security futures
Understanding the difference between options and futures is crucial. American-style options contracts allow holders to purchase or sell the underlying asset before the expiration date, but not necessarily. European alternatives allow for expiration-only exercise but are not mandatory.
The buyer of a futures contract must take ownership of the underlying commodity (or financial equivalent) upon expiry, not earlier. Futures contract buyers can sell at any moment before expiration and be free of obligation. Thus, leverage holders’ positions closing before expiration favor option and futures purchasers.
- Investors can speculate on asset prices via futures contracts.
- Companies can hedge raw material or product prices to safeguard against price changes.
- Brokers may need a partial deposit for futures contracts.
- Futures employ leverage, so investors risk losing more than the margin.
- Hedged companies may lose price gains by investing in futures contracts.
- Margin boosts gains but also loses.
Using Futures Futures in Stock Market
Futures markets frequently involve heavy leverage. Leverage allows traders to trade without putting up 100% of the contract’s value. Instead, the broker requires an initial margin amount, a portion of the contract value.
Broker margin account requirements depend on futures contract size, investor creditworthiness, and broker terms and conditions.
The futures exchange determines whether the contract is for physical delivery or cash settlement. A firm can lock in the price of a production commodity using a physical delivery contract. However, many futures contracts include traders who speculate. Closed or netted contracts result in a cash settlement based on the difference between the original and closing trading prices.
Futures for speculation
A futures contract lets traders bet on commodity prices. Traders who acquired futures contracts and the commodity price increased above the contract price at expiry would profit—closing the extended position by selling the futures contract at the current price before the expiration.
No tangible goods would change hands, and the investor’s brokerage account would get the price difference. The trader may lose if the commodity’s price falls below the futures contract’s buying price.
Some speculators may take a short position if they believe the price of an asset will decline. The trader will close the contract with an offset position if the price drops. Again, contract expiry settles the net difference. An investor would profit if the underlying asset’s price was below the contract price and lose if it was higher.
Note that margin trading allows for more excellent positions than the brokerage account holds. Therefore, margin investing can increase gains and losses.
Imagine a trader with a $5,000 brokerage account and a $50,000 crude oil stake. Oil prices might move against the deal, resulting in losses that surpass the $5,000 original margin. The broker may issue a margin call, asking for extra deposits to offset market losses.
Futures for Hedging
Futures can hedge the price fluctuation of an underlying asset. Instead of speculation, the purpose is to avoid price increases that might hurt. Companies that hedge often use or produce the underlying asset.
Corn growers may lock in a selling price via futures. They eliminate risk and ensure the set price by doing so. The farmer would profit on the hedge if corn prices fell to cover market losses. Hedging successfully locks in an acceptable market price by offsetting gains and losses.
Regulation of Futures
The CFTC regulates the futures markets. Congress established the CFTC in 1974 to protect futures market prices from abusive trading, fraud, and brokerage company regulation.
Examples of Futures Futures in Stock Market
A trader may enter a futures contract in May to bet on the price of crude oil, anticipating a higher price by year-end. The trader buys the $50 December crude oil futures contract.
Oil trades in 1,000 barrels; thus, the investor has a $50,000 holding. Traders merely need to deposit a part of that amount with the broker as the first margin.
Oil prices and futures contracts change from May to December. If oil prices fluctuate, the broker may request more margin account funds. Call this the maintenance margin.
Contract expiration is coming in December (the third Friday of the month). Crude oil costs $65 now. Traders sell initial contracts to exit positions. The net difference is cash-settled. They make $15,000 minus broker fees and commissions ($65 – $50 = $15 x 1000 = $15,000).
If oil had fallen to $40, the investor would have lost $10,000 ($50 – $40 = $10 x 1000 = $10,000).
They’re futures contracts.
Futures contracts allow investors to speculate on the future price of commodities or securities. Many futures contracts exist. These may hold oil, stock market indexes, currencies, and agricultural items.
Unlike individual forward transactions, futures contracts trade on established exchanges like CME Group Inc.. Futures contracts are popular with traders who want to benefit from price volatility and business clients who want to hedge.
Are futures derivatives?
Futures contracts are a sort of derivative instrument. Crude oil futures are derivatives since their value depends on an underlying asset, like oil. Like many derivatives, futures are leveraged and can cause large profits or losses. Since these are advanced trading instruments, only experienced investors and institutions trade them.
Holding a Futures Contract Until Expiration
Cash settlement is typical for traders who hold futures contracts until expiry. The trader will pay or get a cash settlement based on whether the underlying asset rose or declined throughout the investment holding term.
Some futures contracts demand physical delivery. At expiration, the investor holding the contract would receive the asset. They’d pay for products, material handling, storage, and insurance.
- Futures are derivative financial contracts that require buyers and sellers to acquire or sell assets at a defined date and price.
- Futures contracts let investors speculate on financial instruments or commodity prices.
- Futures hedge an underlying asset’s price to avoid losses from price movements.
- Hedging involves taking a position opposite the one you hold with the underlying asset. The futures contract might offset the loss if you lose money on the asset.
- After each trading session, futures contracts’ prices settle on an exchange.