What are Stock Futures?

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Stock traders aim to profit from stock price fluctuations. Depending on the market’s volatility and a trader’s timing, it’s possible to make considerable profits in the stock market. Some assets are tied to individual stocks and offer additional price movement based on changes to the underlying stock’s value. Stock futures are derivatives that exhibit these characteristics. Understanding how they work can make your portfolio more diverse and help you capitalize on additional opportunities. 

How Do Stock Futures Work?

Stock futures allow people to lock in prices on asset purchases. Farmers pay premiums for futures to get guaranteed prices on crops. If the value of a wheat bushel increases by $1, a farmer can use their futures contract to get wheat at a lower price. 

Futures traders have taken this concept and expanded it to stocks. Stock futures obligate the buyer to purchase shares at the strike price, and the seller is obligated to follow through on the stock futures. Unlike stock options, both parties are obligated to follow through on stock futures, but you can sell out of the future position before the expiration date. Each stock future obligates the movement of 100 shares from a seller to a buyer at expiration.

Margin and Leverage

Stock futures give you exposure to more assets for less capital. The price of each futures contract is based on 100 shares. You don’t have to raise enough capital to buy 100 shares to obtain a futures contract. Brokers will require an initial investment but give you enough margin to cover the rest of the purchase. You may only have to put 20% down to get a stock futures contract, depending on your broker. 

It’s possible for your money to grow considerably if you buy stock futures, but this depends on the underlying asset’s performance. While leverage can help investors realize gains, the strategy can go wrong in a hurry if the underlying stock’s price moves in an undesirable direction. Margin risks wiping out all of your portfolio’s gains and making your balance negative in extreme scenarios. Leverage lets you enter a larger position with the same money, amplifying potential gains and losses in the process.

Calculating Stock Futures

Many brokers provide stock futures prices for you, but it’s good to understand how the calculation works. Knowing the factors that make up stock futures can help you gauge how prices will change in the future. 

These are the components of the futures price formula. 

• Spot price = the stock’s current price in the market
• RF = risk-free rate
• X = number of days until expiration
• D = dividend

Here is the formula:

Futures price = Spot price x (1 + RF (X/365) - D)

Assume a stock sells at $150 per share without a dividend. The risk-free rate is 5%, and the expiration date is 73 days away. Using this information, it is possible to arrive at the price of a futures contract.

Futures price = 150 x (1 + 0.05 (73/365) - 0)

Futures price = 150 x (1 + 0.01) = 150 x 1.01 = 151.50

Advantages of Stock Futures

Stock futures give traders several advantages that make them useful additions to some portfolios:

• Higher potential returns: It is possible to earn more with stock futures than individual stocks.
• Leverage: If you do not have enough available funds to buy 100 shares, you can still benefit from the price movement of 100 shares through futures contracts.
• After-hours trading: You can trade stock futures after hours and are not limited to making trades from 9:30 a.m. Eastern to 4 p.m. Eastern. If there is activity after hours such as strong earnings or a major news event, you can position yourself accordingly with stock futures.
• You can hedge your positions: Some investors use stock futures to lock in a price they can sell their assets, similar to a farmer looking to buy crops at a fixed price. Futures allow you to secure a selling price regardless of market volatility.

Risks Associated with Stock Futures

No investment opportunity is perfect, and it is important to know the risks of stock futures before getting started. Knowing the risks can help you understand the potential loss and make decisions based on your risk tolerance. These are some details you should keep in mind.

• Futures contracts can rapidly lose value leading up to expiration: Futures lose value as the expiration date gets closer, but contracts out of the money lose value substantially faster.
• Losses from leverage: Margin works well when you time the market well, but making a few mistakes can wipe out your gains and potentially your entire portfolio. Leverage is risky and not for beginners. You should consider what you can gain from leverage that you can’t gain through other methods before using it for your portfolio.
• You will have to monitor the market more often: Small price fluctuations can have a significant impact on the value of your futures contracts. You may end up refreshing your portfolio screen throughout the day and obsessing over market news.

Where to Invest in Stock Futures

Ready to get started with stock futures? Several brokerages make it possible to trade futures and profit from price fluctuations.

Do Stock Futures Fit In Your Portfolio?

Stock futures let investors use leverage, and they can also help with hedging. These derivatives have more risks than underlying stocks, but the potential rewards can exceed what you can get from individual stocks. Assessing your risk tolerance can help you decide whether stock futures make sense for your portfolio.

Frequently Asked Questions