What are futures?

Futures are a financial contract between parties to buy or sell an asset (either a security, financial instrument, or commodity) at a specific price on a predetermined date in the future. These standardized derivative agreements are traded on futures exchanges, such as the Chicago Mercantile Exchange. A principle use of futures contracts is to hedge against adverse price fluctuations of an underlying asset. Additionally, futures can be used to speculate on the price movement of assets.

With futures, the specific price agreed upon to buy or sell an asset is deemed the “forward price”. The predetermined date in the future when payment and delivery transpire is referred to as the “delivery date”.

It is crucial to understand with futures, that the parties who enter the contract are obligated to follow through with the particulars of the specific contract – either to buy or sell by the delivery date.

How do futures work?

Here is an example of how futures contracts work:

Company A produces cheese, and purchases milk from Company B which operates as a dairy farm. Company B sells the milk for $2 a gallon. Another dairy farm opens which increases the number of milk-producing cows, therefore increasing the supply of milk. Thus, the price of milk drops to $1 a gallon. Company A is enjoying profits because it now costs less to produce their cheese. However, Company B is obviously losing money because of the decreased price of milk. Suddenly, an illness affects the milk production of the majority of cows. The price of milk now increases to $4 a gallon. Consequently, Company A’s profit from cheese declines drastically. 

Obviously, companies want to hedge against this type of volatility, so they broker futures contracts with investors. The particulars of Company A’s contract stipulate that if milk prices increase above $2, then the investor pays the difference, and the company pays the locked-in price of $2. Should milk prices decline, then the investor profits from the gains, and Company A still pays $2 for milk.

Types of Futures

There are numerous types of futures contracts available at futures exchanges such as:

• Commodity futures such as oil, corn, and even pork bellies.
• Stock index futures tracking benchmark indexes like the S&P 500 
• Currency futures trading in currency from around the world such as the British Pound or the Japanese Yen.

Every futures product is different, yet, each one does contain some key contract specifications including:

Trading hours – Each product has its own trading hours, which are dependent on several factors such as asset class, etc.

Tick size – This denotes the minimum amount that the price of a specific contract can change. Tick sizes and values are vastly different, dependent solely on the specific contract.

Quantity – This is the standardized quantity of a given commodity or financial instrument in a contract that does not fluctuate. For instance, one contract unit of crude oil is always represented by 1,000 barrels.

Notional value – This is the present market value of the specific commodity or financial instrument.

Settlement – Each product specifies the settlement of the contact, be it physical delivery or settled in cash.

What is futures trading?

Many different parties utilize the futures markets, be it companies hedging against price volatility, investors, or speculators (those speculating on the price movement of assets). Regarding a futures contract, the party that agrees to buy the asset and pays the forward price is considered going “long” on the contract. The party that sells the asset at the forward price “shorts” the contract.

Below is an example to give you a better idea of futures trading:

Presume that you feel that a recession is on the horizon and investors will flock to gold as a hedge, thus increasing its value. The current market price (or “spot price” as it is known) of gold is, say, $1,600 per ounce. However, you would prefer to invest in the futures market, rather than invest in the physical precious metal. Therefore, you enter a futures contract where you can get 100 ounces of gold in 12 months for a forward price of $1,650 per ounce. You go long on the contract, agreeing to purchase $165,000 (100 x 1,650) of gold. Your return on the investment will be dependent on the spot price of gold in 12 months. If in a year the gold price increases to, say, $1,850, then you sell at the spot price and have a $20,000 profit (100 x 1,850 = $185,000). Yet, should the gold spot price decline to, say, $1,450 per ounce, then you lose $20,000 (100 x 1,450 = $145,000) because you are obligated to purchase the gold at the higher spot price of $1,650 per ounce.

Conversely, if you feel that gold prices will decline in a year, then you go short on the same futures contract, agreeing to sell the gold at $1,650 per ounce in 12 months. Therefore, in a year you purchase the 100 ounces of gold at $1,450 per ounce, and sell it for $1,650 per ounce, thus having a $20,000 profit.

As with any investment vehicle, futures come with risks – specifically, leverage and margins. Futures utilize leverage, which enables speculators to only invest a small proportion of the contract’s value. When entering a futures contract, brokers only require a margin, which is a small percentage of the total value of the contract, say for instance, 5%. However, should the market move contrary to where an investor presumed, there can be significant losses. Again, parties who enter a futures contract are obligated to follow through with the particulars of the specific contract. 

However, it is crucial to understand that futures trading is speculative, has the potential for significant financial loss, and is NOT appropriate for all investors.

Popular Futures Brokers

In order to trade futures on the futures market, you must first set up an account with a brokerage firm. Because there are numerous futures trading brokerages, the choices can be a bit overwhelming, especially for beginners. Here are some of the most popular and respected futures trading brokers.

Charles Schwab Futures Trading

Charles Schwab is one of the biggest and most revered financial services companies in the world. The company has received exceptional reviews as a futures brokerage, and provides an excellent experience for investors.  In addition to the expert support provided from futures specialists, Charles Schwab has no account fees or broker-assisted futures trading fees.

E*Trade Futures Trading

E*Trade is a good choice for investors who want professional guidance, in addition to access to comprehensive research tools and market data that is intuitive and user-friendly. 

Comparison Table On The Different Types Of Trading

Here is a comparison table examining the different types of trading.

Futures Trading FAQs