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Futures Trading in the Stock Market: A Comprehensive Guide to Definition, Examples, and Strategies

Last updated 05/15/2024 by

SuperMoney Team

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Summary:
Futures are financial contracts that enable traders to speculate on the price movements of assets or commodities by obligating the buyer or seller to purchase or sell an underlying asset at a predetermined future date and price, regardless of the current market price. Futures trading offers traders the advantage of locking in the price of the asset or commodity and allowing them to hedge against price fluctuations. Futures contracts trade on a futures exchange, and they are categorized by their expiration month. Leverage is a critical component of futures trading, allowing traders to enter into a trade with only a fraction of the contract value. While leverage can result in substantial gains, it can also amplify losses.

Definition

Futures are financial contracts that enable traders to speculate on the price movements of assets or commodities by obligating the buyer or seller to purchase or sell an underlying asset at a predetermined future date and price, regardless of the current market price. Futures trading offers traders the advantage of locking in the price of the asset or commodity and allowing them to hedge against price fluctuations. Futures contracts trade on a futures exchange, and they are categorized by their expiration month. Leverage is a critical component of futures trading, allowing traders to enter into a trade with only a fraction of the contract value. While leverage can result in substantial gains, it can also amplify losses.
Futures are financial contracts that derive their value from an underlying asset, such as commodities or financial instruments. The contract obligates the buyer and seller to transact the underlying asset at a predetermined future date and price. The buyer must buy and the seller must sell the asset at the set price, irrespective of the market value at the contract’s expiration date.
Futures contracts define the quantity of the underlying asset and are standardized to enable trading on a futures exchange. Investors use futures contracts to hedge or speculate on market movements.

Discovering the world of futures trading

If you are looking for a way to lock in the price of an underlying asset or commodity, futures trading may be just what you need. These contracts offer traders the ability to know the price and expiration date upfront, allowing them to plan and strategize their trades accordingly.
Futures are categorized by their expiration month, which means that traders can purchase a contract that expires in a specific month. For example, a December gold futures contract would expire in December. But there’s more to futures trading than just picking an expiration date.
Futures trading is not only a way to speculate on the price of an asset or commodity, but it’s also used for hedging against price fluctuations. By taking an opposite position in a futures contract, traders can help prevent losses from unfavorable price changes in the underlying asset.
Futures contracts are traded on a futures exchange, allowing traders to buy and sell contracts at any time during the trading session. The market demand determines contract prices, which are settled at the end of each trading day.
There are many different types of futures contracts available for trading, each with its unique characteristics and specifications, including:
  • Commodity futures contracts involve assets such as crude oil, natural gas, corn, and wheat.
  • Stock index futures contracts involve underlying assets such as the S&P 500 Index.
  • Currency futures include futures for the euro and the British pound. Precious metal futures allow traders to trade gold and silver.
  • U.S. Treasury futures can be used to trade bonds and other financial securities.
It’s crucial to understand the differences between options and futures. American-style options contracts grant the holder the right (but not the obligation) to purchase or sell the underlying asset at any time before the expiration date. With European options, you can only exercise at expiration but don’t have to do so.
However, when it comes to futures contracts, the buyer is obligated to take ownership of the underlying commodity (or the financial equivalent) at the time of expiration, but not before. While the buyer of a futures contract has the freedom to sell their position at any time before expiration, they are still responsible for fulfilling their obligation. By closing out their positions before the expiration date, buyers of both options and futures contracts can benefit from a leverage holder’s position.

The benefits and drawbacks of futures trading

Futures contracts offer several advantages and disadvantages for investors and businesses.
Advantages:
Futures contracts have various applications. Traders can speculate on price movement and make a profit, while companies can hedge against unfavorable price changes for raw materials or products. Futures contracts also require only a fraction of the contract amount as a deposit, making them accessible to a wider range of traders.
Disadvantages:
Futures contracts have risks for investors due to their use of leverage, which can amplify losses beyond the initial margin amount. Companies using futures to hedge positions may miss out on favorable price movements, reducing potential profits. While margin can increase gains, it can also amplify losses, so caution is advised when trading futures.

Futures applied

In the world of futures trading, high leverage is often used. Leverage allows traders to enter into a trade without putting up the full value of the contract. Instead, a broker will require an initial margin, which is a fraction of the total contract value. The required margin can vary depending on factors such as the size of the futures contract, the investor’s creditworthiness, and the broker’s terms and conditions.
Futures contracts can be either physically settled or cash-settled, depending on the exchange where the contract trades. While physical delivery contracts are used by corporations to hedge against price fluctuations, most futures contracts involve traders speculating on the market. These contracts are closed out by calculating the price difference between the original and closing trade and settling it with cash.

Speculation and futures

A futures contract allows traders to speculate on the direction of a commodity’s price, whether it’s a physical commodity like crude oil or a financial instrument like a stock index. If a trader buys a futures contract and the price of the underlying commodity rises, they can sell the contract at the current price and make a profit.
On the other hand, if the price of the commodity falls, the trader could lose money. When the contract expires, the difference between the original price and the closing price is cash-settled in the trader’s brokerage account. This means that no physical product actually changes hands.
Futures trading utilizes high leverage where traders only need to deposit a fraction of the total contract value known as the initial margin amount. Leverage can result in substantial gains, but it can also amplify losses.
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Traders can also take a short speculative position in futures if they anticipate that the price of the underlying asset will drop. In this case, if the price indeed falls, the trader would close out the contract with an offsetting position. At the end of the contract, the net difference would be settled. If the current price is lower than the contract price, the trader would realize a profit. Conversely, if the current price is higher than the contract price, the trader would incur a loss.
Trading on margin is a useful tool that allows investors to open larger positions than what their brokerage account holds. However, this increased buying power comes with a catch: while margin investing can magnify gains, it can also amplify losses.
Consider a scenario where a trader has a $5,000 brokerage account balance and a $50,000 position in crude oil. If the price of oil moves in the opposite direction of the trade, the resulting losses can be significantly higher than the initial margin of $5,000. Consequently, the broker may issue a margin call, requesting additional funds to cover the market losses.

Hedging and futures

Futures can serve as an effective tool for hedging against the price fluctuations of an underlying asset. Rather than speculating for profit, hedgers use futures to protect against potential losses caused by unfavorable price movements. This is especially common for companies that produce or utilize the underlying asset in their operations.
For instance, a corn farmer could use futures to lock in a specific price for selling their corn crop, thereby reducing their risk and ensuring they receive the agreed-upon price. If the price of corn were to drop, the farmer could gain from the hedge to offset the losses from selling the corn on the market. In this way, the hedging effectively secures an acceptable market price by offsetting gains and losses against each other.

Futures and regulations

The integrity of futures market pricing is ensured by the Commodity Futures Trading Commission (CFTC), a federal agency established by Congress in 1974. The CFTC’s responsibilities include preventing abusive trading practices, fraud, and regulating brokerage firms involved in futures trading.

Futures in the real world

Suppose a trader wants to make a bet on the future price of crude oil. They believe the price will rise by the end of the year, so they decide to enter into a futures contract for crude oil in May. The December crude oil futures contract is currently priced at $50, so the trader buys the contract.
Now, as crude oil is traded in 1,000-barrel increments, the trader’s position is worth $50,000 of crude oil (1,000 x $50 = $50,000). However, the trader does not need to pay the entire amount upfront. Instead, they need to deposit only a fraction of the total amount – the initial margin – with the broker.
Let’s say a trader buys a futures contract for crude oil in May, expecting the price to increase by December. The futures contract has a value of $50,000 for 1,000 barrels of oil. However, the trader only needs to deposit an initial margin with the broker, a fraction of the contract’s value, to open the position. Over the months, the price of oil fluctuates, and if it becomes too volatile, the broker may require additional funds to be deposited in the margin account, known as maintenance margin.
In December, the contract is nearing expiration, and the price of crude oil has risen to $65. The trader decides to sell the contract and exit the position, settling the net difference in cash. They earn a profit of $15,000, minus any fees and commissions payable to the broker. Conversely, if the price of oil had dropped to $40, the trader would have suffered a loss of $10,000. It is essential to note that trading futures involves risks and rewards and may result in significant losses or gains.

Futures contracts defined

Futures contracts offer investors a way to speculate on the future price of various securities or commodities. These contracts come in many types, with underlying assets ranging from agricultural products to currencies, stock market indices, and oil. Unlike forward contracts, which are tailored to individual parties, futures contracts are traded on organized exchanges, like those run by the CME Group. Futures contracts are popular among traders looking to profit from price swings, as well as commercial customers seeking to hedge their risks.

Are futures considered a type of derivative?

Futures contracts are a type of derivative that derive their value from an underlying asset, such as crude oil. They are leveraged financial instruments that offer high potential gains or losses. Futures are generally considered to be a sophisticated trading tool, and are typically traded by skilled investors and institutions.

What happens when you hold a futures contract until expiration

Futures traders can settle their positions in cash instead of taking physical delivery of the underlying asset upon expiration. They will receive or pay a cash settlement based on the asset’s price changes during the holding period. However, some futures contracts mandate physical delivery upon expiration, which means that the investor must take delivery of the asset and cover associated costs, such as material handling, physical storage, and insurance.

Key takeaways

  • Futures are a type of derivative financial contract used for speculation or hedging.
  • They obligate the buyer or seller to purchase or sell an asset at a predetermined future date and price, regardless of the current market price.
  • These contracts allow investors to speculate on the price of financial instruments or commodities and are also used for hedging to prevent losses from unfavorable price changes.
  • In hedging, investors take a position opposite to the one they hold with the underlying asset to mitigate losses.
  • Futures trade on a futures exchange, and the contract’s price settles at the end of every trading session.

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