What Are Futures? How Do They Work as Investments?

If you read any investing focused sites such as CNBC, chances are you’ve heard the term futures.

Some people buy or sell futures like other types of investments to try to make a profit. 

But what are futures? How do they work as investments?

Here’s what you need to know.

What Are Futures?

The term "futures" refers to futures contracts.

A futures contract is an agreement that states you will buy or sell a particular asset on a specific future date at a specific price. It is a type of financial instrument.

Futures contracts that are traded as investments are standardized so they can be traded on futures exchanges. This allows you to buy and sell futures contracts easily.

Popular exchanges where futures are traded include:

  • Chicago Board of Trade
  • Mercantile Exchange
  • Intercontinental Exchange

Futures contracts can cover many types of potential future transactions.

Some examples include:

  • Stock indices (e.g., S&P 500)
  • Metals (e.g., gold)
  • Crops (e.g., corn)
  • Currency (e.g., USD)
  • Commodities (e.g., natural gas or oil)

A futures contract doesn’t have any value on its own.

Instead, the value of the contract is based on other aspects such as the current prices of the goods specified in the contract.

Because the value is derived from something other than the contract itself, futures contracts are considered derivative investments.

Components of Futures

A futures contract has many components you must be aware of.

Type of asset

The contract will specify exactly what asset you’re promising to buy or sell.

Futures contracts can offer a wide variety of assets for a buyer or seller.

For instance, a farmer may want to sell a futures contract for the crop they grow to lock in a price today.

Quantity

Futures contracts also specify exactly how much of an asset you will be buying or selling.

In the case of oil, the contract would state how many barrels of oil would change hands when the contract expires.

Contract expiration

Another important part of a futures contract is the contract expiration date.

When the contract expires, the contract must be settled.

That means the buyer must pay the price specified in the contract and the seller must provide the specified asset.

Price

In order to settle a contract, there must be a contract price.

While there may be price movement in the value of the contract at any given time before the contract expires, the contract price is different.

The contract price is the specific price the contract holder must pay the seller once the contract expires to receive the asset.

Based on the current market, the actual price you pay for the contract itself may be higher or lower.

The price should also note what currency is being used.

Delivery terms

The delivery terms specify how a buyer and seller will settle the futures contract.

Different futures contracts have different delivery terms. Some futures contracts require physical delivery of the asset the contract is for. 

In the case of barrels of oil, the buyer would have to take delivery of the oil the contract specifies. This makes the most sense when dealing with futures contracts for commodities such as corn, oil or gold.

Not all contracts require physical delivery of the asset, though. Instead, some contracts specify that they will be settled in cash.

For example, you can’t deliver a stock index to a house. 

Instead, the contract is settled in cash by paying the loss or gain compared to the current market prices.

Reasons You May Consider Trading Futures

Futures are a very versatile type of investment that can be used in many different ways depending on the person buying or selling the contract.

1. Hedging against price gains

Companies can use futures contracts as a way to hedge against increasing prices in particular commodities.

Cruise lines use quite a bit of oil to power many of their cruise ships. As such, the price of oil is one of the key costs in their business. 

To prevent a spike in oil prices from dragging down their profits, cruise lines may opt to buy oil futures contracts.

By buying a futures oil contract, they know exactly how much the oil will cost them when the contract expires. 

If the price of oil drops, the cruise line would lose money.

However, the cruise line would come out ahead of the price of oil is above the contract price at the time it expires.

2. Locking in prices

Another common way to use futures contracts is by using them to lock in prices. 

Farmers may want to have certainty about how much money they’ll make from this year’s crop. They may decide to sell a futures contract to deliver corn at a future date at a set price.

By selling their future harvest with a futures contract, farmers know how much money they’ll get later in the year. This can help them with their financial planning.

Unfortunately, this could cause problems for farmers. If their crop gets damaged, they still have to sell the amount of the crop they said they’d sell in the contract. 

This would require them to buy the crop from someone else to fulfill their end of the contract. Insuring their crops can help offset this potential issue.

3. Speculation

Futures contracts can also be used as a way to speculate. Individuals can buy and sell futures contracts as an investment.

If the price of the underlying asset becomes favorable to the contract you bought or sold, you could make money.

Of course:

The opposite is also true.

If the price becomes unfavorable to the contract you bought or sold, you could lose money, too.

What You Need to Trade Futures

In order to make futures trades, you’ll need to have a brokerage account that allows you to do so. 

Certain types of brokerage accounts allow you to buy a futures contract, but not all do

After you have a general brokerage account, you usually must apply for the ability to trade options and to trade on margin

The brokerage firm will generally ask questions about your income, net worth and your investing experience before extending you margin. They don’t want to lose money because you can’t hold up your end of the deal. 

Part of the application will state the margin requirements you’ll need to maintain to continue trading in the account, as well.

Once you have access to options and margin trading, you can usually begin trading futures within your brokerage account.

Look:

When you’re trading on margin, you must be careful.

Trading on margin allows you to borrow money to make bigger investments. This comes at the cost of paying interest.

Trading on margin can make your winning trades result in even more profits. They can also make your losing trades turn into huge losses. 

Do not trade futures on margin unless you understand all of the risks involved.

An Example of How Trading Futures Works

While trading futures can be complex, it’s important to remember what is really going on behind the scenes.

Here’s a concrete example to help you understand exactly how trading futures works.

A natural gas producer wants to secure its future revenues without worrying about potential price decreases in the future.

At the same time:

A company that delivers natural gas to homeowners to heat their homes wants to lock in their natural gas prices to avoid a potential future price increase.

  • The natural gas producer sells a futures contract to lock in the price today.
  • The natural gas delivery company buys a futures contract to do the same. 

The futures contract states the natural gas producer will sell a set quantity of gas in December of that year.

The natural gas delivery company will take delivery and pay for the natural gas at that time. 

The futures contract states a price in dollars based on the amount of natural gas being sold.

Neither company decides to sell their ownership in their respective futures contracts because they both want to continue hedging their perspective risks.

Then:

When the contract expires in December, the natural gas delivery company pays for the natural gas based on the amount set in the contract. The natural gas producer then delivers natural gas based on their contractual obligations.

At any time during the contract, the natural gas supplier could have sold their futures contract to another person willing to fulfill the contract and supply the natural gas.

The natural gas delivery company could have sold their futures contract (to buy the gas) to another person willing to buy the gas at the set contract price.

If either company had sold their rights in the contract, the price they received for their rights in the contract would need to be determined. 

The markets determine the price by what people are willing to pay for the contract.

In general, this is partially done by looking at the difference between the contract price for natural gas and the current market price for natural gas. 

It also takes into account the amount of time until the contract expires and whether people think the current market prices will go up or down.

You Decide

Now if someone asks you what are futures, you can explain it to them.

You can also decide if you want to trade futures contracts on futures markets or if you’d rather stick to other types of investments.

While futures contracts are just financial instruments, they can be extremely tricky to master

You should consult with a financial advisor to see if trading futures contracts is suitable based on your financial knowledge, situation and goals.

They can help you understand the risks involved and help you create a strategy if you do decide to trade futures.

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