What are Futures?

Understanding futures

If you know that you’ll need something in the future and it’s currently being sold at a good price, you have the option to purchase it now and store it for later use. These contracts involve the buyer and seller reaching an agreement on the price, quantity, and future delivery date of an asset in advance. When investing in futures, you can take on the role of either a buyer or seller. Buyers hope for an increase in the asset’s price, while sellers anticipate a decrease. Investors can trade futures contracts for various commodities (such as corn, orange juice, or gold) and financial instruments (like foreign currencies or stock indexes) in order to potentially profit from market price fluctuations.

Simple Explanation

Futures contracts originated from our necessity to consume food.…

Ages ago, people understood the importance of securing enough food for the upcoming harvest to stay alive. The farmers were keen on selling their crops at a fair price before the market got flooded with produce, causing prices to plummet. So, both the farmers and the buyers reached an agreement on a fixed price for a portion of the harvest beforehand. This arrangement ensured that the farmers got a decent price and the buyers had food on their plates.

What are futures?

The terms futures contracts and “futures” are synonymous. Traders can use commodity futures to speculate on the future prices of commodities such as gold, natural gas, and orange juice.

With financial futures, traders have the opportunity to speculate on the future prices of different financial assets like stocks, treasury bonds, foreign currencies, and financial indexes (mathematical averages that provide insights into the performance of specific markets like stocks, treasuries bonds, and currencies). They can even trade futures contracts for Bitcoin, which is a type of cryptocurrency.

Futures traders have the option to be either a buyer (long position) or a seller (short position). When the price rises, the buyer profits from purchasing the asset at a lower price. Conversely, when the price drops, the seller profits from selling at a higher price.

Retail traders don’t really want to keep futures contracts until they expire. They prefer to close their contracts when they can make a profit from the difference between the contract price and the current market price, or if they’re facing losses and want to get out.

Retail traders should always be mindful of the expiration date of their contract. When it comes to futures contracts, some settlement methods upon expiration may call for the physical delivery of an asset instead of a cash settlement.

Getting an unexpected cash payout due to a contract expiration can be costly. However, if you hold a long position (buyer position) on a futures contract for 15,000 pounds of frozen orange juice with a “deliverable” settlement method and allow the contract to expire, you might receive a delivery notice directing you to collect all that delicious orange goodness.

What’s in a futures contract?

Futures exchanges ensure that futures contracts are standardized by specifying all the contract details. You can review these specifics on the exchange’s website. Contracts specify:

• Assets traded in the market, such as oil, corn, and Bitcoin.
• The quantity traded can vary, like 1000 barrels of oil, 5000 bushels of corn, or 5 BTC.
• If it’s a commodity, the quality of the asset may differ, like various types of crude oil.
• Prices are usually quoted in dollars, cents, or even fractions of cents.
• The smallest price fluctuation determines how much each tick up or down is worth.
• The trading hours depend on the specific asset being traded.
• Contracts have an expiration date, also known as the Delivery Date.
• Upon expiration, settlement can be done through physical delivery of the asset or cash settlement.

What is a futures exchange?

Futures are bought and sold on futures exchanges, which are basically like marketplaces for trading futures. Each futures contract is traded on its own specific exchange. The United States has a total of eight futures exchanges:

• Chicago Board Options Exchange (CBOE / CFE)
• Chicago Climate Exchange (CCX)
• CME Group International Monetary Market (IMM)
• Intercontinental Exchange (ICE)
• Minneapolis Grain Exchange (MGEX)
• Nadex
• Nasdaq Futures Exchange (NFX)
• OneChicago (Single-stock futures (SSF’s) and futures on Exchange traded funds (ETFs)

Retail traders can access futures trading by setting up an account with a registered futures broker, while only futures brokers and commercial traders who are exchange members can trade directly on the exchange.

What are margins in futures trading?

If you’re looking to enter a futures contract, it’s as simple as depositing a percentage (known as initial margin) of the contract’s total value into your futures broker account. The initial margins are determined by the futures exchanges and can vary anywhere between 4% and 15% of the contract’s total value.

At the end of each trading day, futures exchanges compare the price of a futures contract to the current market price of the underlying asset (known as mark-to-market.) After that, futures brokers update their traders’ accounts by adding or subtracting money, depending on whether the trader is making a profit or a loss. Traders must always maintain a minimum amount in their account (also known as maintenance margin) to cover any potential daily losses.

If a trader’s maintenance margin account doesn’t have enough funds, the broker should notify them to add more money, which is called a margin call. If the trader doesn’t deposit the required funds, they will be forced to abandon their position on the futures contract.

How do you close out a futures contract?

There are two ways for traders to prevent their contracts from expiring.

Close their position by offsetting. Retail traders can close their position by offsetting, which means entering the opposite position on the same contract. For example, if a trader is long on gold (buyer position) and wants to close their position, they can enter a short position (seller position) on the same gold contract with the same expiration date. Traders change their position on a contract to either lock in profits or bail out if they’re incurring losses.

Extend the contract with a rollover. Traders who want to hold onto their position in a contract even after it expires can roll it over to a new contract with a different expiration date. It’s important for traders to be aware of the various deadlines for rolling over different futures contracts.

How does trading stock index futures work?

Stock indexes measure the value of a group of stocks using a mathematical average to show a particular market or segment performance. The value is represented in points.

When you trade stock index futures, you’re essentially speculating on whether the index will experience an upward or downward trend in the future. Take the S&P 500 as an example, it’s a futures contract designed to mirror the S&P 500 index. It has a multiplier of $250, meaning that every point of movement in the S&P 500 index is valued at $250.

Let’s say you sell an S&P 500 futures contract with an agreed-upon future index value of 3040. If the index increases by 5 points to 3045, you’ll lose $1,250 (5 index points times $250.) On the other hand, if it decreases by 5 points to 3035, you’ll gain $1,250.

The CME Group, also known as the Chicago Mercantile Exchange, provides smaller contracts that track the S&P 500, Russell 2000, Nasdaq 100, and Dow Jones indices. These contracts come with smaller multipliers.

For example, the E-mini S&P 500 futures contract comes with a $50 multiplier, meaning that every index point the S&P 500 goes up or down is equivalent to $50. The Micro E-mini S&P 500 comes with a $5 multiplier. The Micro E-mini Nasdaq-100 has a multiplier of $2, while the Micro E-mini Dow Jones has a $0.50 multiplier. Starting with smaller futures contracts can help new traders manage risk better.

How to get started with trading futures?

If you want to get into futures trading, the first step is to open a trading account with a registered futures broker. Some brokers who deal with stocks may also have the license to trade futures.

Not all futures brokers provide the same level of educational resources and support. You might find that online brokers have virtual trading platforms for you to practice on before diving into the real thing.

When you’re looking into brokers, there are a few things you should compare:

1. Check out their fees and commissions
2. What types of futures contracts they offer
3. The level of education and help they provide
4. Look into their online trading platform
5. Find out the minimum amount required to open an account and their margin requirements

If you’re 18 or older, you can get into futures trading, but it’s not recommended for beginners. Make sure to do your research or seek out educational resources before taking the plunge.

What are the pros vs. cons of futures trading?

Pros

• Barriers to entry are low. With initial margins below $1000, the barriers to entry for Micro E-mini stock index contracts are quite low, making it easy to get started.
• You could potential earn more money with less than with stocks. Trading futures with low initial margins can provide you with greater leverage compared to borrowing money from your broker to invest in stocks. This means you can potentially make larger gains with a smaller investment.
• There are tax advantages. If you sell stocks or Forex for a profit within a year of owning them, you’ll be subject to short-term capital gains tax, which is the same rate as your regular taxable income. Futures profits, on the other hand, are taxed under the 60/40 rule: 40% of profits are taxed at short-term capital gains rates, while the remaining 60% are taxed at long-term capital gains rates, which can be 0%, 15%, or 20% based on your taxable income and filing status.
• Futures contracts don’t have any Pattern Day Trader rule. A Pattern Day Trader is someone who makes four or more trades within five days using the same margin account. If you’re into stocks or options, you better have at least $25,000 in your brokerage account. That’s what Financial Industry Regulatory Authority (FINRA) requires to keep trading. Futures traders have it easier since these rules don’t apply to them.

Cons

• You may take on more risk. Trading futures allows you to use less money upfront compared to stocks, giving you the ability to trade with more money. But with more money comes the risk of losing more money.
• Futures expose you to unlimited liability. When the market price of an asset keeps moving against you, it means you’ll keep losing money until you either close your position or your maintenance account becomes empty. In the event of a sudden and extreme price swing, you might find yourself owing money to your broker.
• You may end up losing your investment before you even get the chance to win. Futures brokers make daily adjustments to traders’ accounts. A sudden market swing could deplete your maintenance margin account and prematurely close your contract position. You could miss out on potential gains if the price swings in your favor later.

Trading futures comes with a lot of risk and may not be the best option for everyone. You could end up losing a significant sum of money in a short amount of time. The amount you could lose is unlimited and may go beyond your initial deposit with your broker. This is due to the high leverage involved in trading security futures, where a small amount of money can control assets of much higher value. If you’re not comfortable with this level of risk, it’s best to avoid trading futures.

Due to the leverage and nature of futures transactions, you might experience the impact of your losses right away. In certain market conditions, it could be challenging or even impossible to protect yourself or sell off a position. Additionally, the prices of security futures may not always follow their usual or expected patterns in relation to the underlying security or index.