What Is Futures Trading?

What Is Futures Trading?

Futures are contracts to buy or sell a specific underlying asset at a future date. The underlying asset can be a commodity, a security, or other financial instrument. Futures trading requires the buyer to purchase or the seller to sell the underlying asset at the set price, whatever the market price, at the expiration date.

Futures trading commonly refers to 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. Futures trading on exchanges like the Chicago Mercantile Exchange can include underlying "assets" like physical commodities, bonds, or weather events.

Underlying Assets

Futures traders can 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. The underlying assets in futures contracts may include:

• Commodity futures with underlying commodities such as crude oil, natural gas, corn, and wheat
• Cryptocurrency futures are based on moves in assets like Bitcoin or Ethereum
• 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 other 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

How Futures Trading Works

Futures contracts are standardized by quantity, quality, and asset delivery, making trading them on futures exchanges possible. They 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. This ensures market transparency, enhances liquidity, and aids in accurate prices.

Stock futures have specific expiration dates and are organized by month. 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 to the next available contract month. Short-term traders often work with front-month contracts, while long-term investors might look further out.

When trading futures of the S&P 500 index, traders may buy a futures contract, agreeing to purchase shares in the index at a set price six months from now. If the index goes up, the value of the futures contract will increase, and they can sell the contract at a profit before the expiration date. Selling futures works the other way around. If traders believe a specific equity is due for a fall and sell a futures contract, and the market declines as expected, traders can buy back the contract at a lower price, profiting from the difference.

Speculation

A futures contract allows a trader to speculate on a commodity's price. If a trader buys a futures contract and the price rises above the original contract price at expiration, there is a profit. However, the trader could also lose if the commodity's price was lower than the purchase price specified in the futures contract. Before expiration, the futures contract—the long position—can be sold at the current price, closing the long position.

Investors can also take a short speculative position if they predict the price will fall. If the price declines, 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 gains if the underlying asset's price is below the contract price and loses if the current price is above the contract price.

Suppose a trader chooses a futures contract on the S&P 500. The index is 5,000 points, and the futures contract is for delivery in three months. Each contract is $50 times the index level, so one is worth $250k (5,000 points × $50). Without leverage, traders would need $250k. In futures trading, traders only need to post a margin, a fraction of the contract's total value. If the initial margin is 10% of the contract's value, the trader deposits only $25,000 (10% of $250,000) to enter the futures contract. If the index falls by 10% to 4,500 points, the value of the futures contract decreases to $225,000 (4500 points x $50). Traders face a loss of $25,000, which equals a 100% loss on the initial margin.

Hedging

Futures trading can hedge the price moves of the underlying assets. The goal is to prevent losses from potentially unfavorable price changes rather than to speculate. 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, the fund manager hedges the portfolio against a possible market downturn using S&P 500 futures contracts.

Assume the S&P 500 is at 5,000 points and 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, assume a 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 with two possible outcomes:

• The S&P 500 index dropped 10% down to 4,500 points over three months, which means the portfolio would likely lose about 10% of its value, or $10 million. 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 goes up over 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.
  

Pros and Cons of Futures Trading

Futures trading comes with advantages and disadvantages. Futures trading usually involves leverage and the broker requires an initial margin, a small part of the contract value. The amount depends on the contract size, the creditworthiness of the investor, and the broker's terms and conditions.

Futures contracts can be an essential tool for hedging against price volatility. Companies can plan their budgets and protect potential profits against adverse price changes. Futures contracts also have drawbacks. Investors risk losing more than the initial margin amount because of the leverage used in futures.

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. Taking 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.