What Are Futures Contracts?

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Stocks are fairly easy to understand. When you buy shares of a public company, you’re buying a little stake of ownership in the business. Owning shares means you have equity in the firm, and you’re entitled to a portion of the company’s profits.

Futures are more complicated. Futures are a derivative of another underlying asset at a certain price in the future. 

Still unsure about what futures are and what they can offer you? Learn more about futures now with Benzinga’s guide.

What Are Futures?

First off, what are futures? In simple terms, futures contracts are financial agreements between two parties to buy or sell an asset at a predetermined price and date in the future.

When you buy futures, you’re buying contracts that specify delivery of the underlying asset at a certain price at a future date. Futures contracts can be based on all kinds of assets: commodities like gold and oil, stocks and stock indices, bonds or currencies, cryptocurrencies and other financial markets to hedge against price fluctuations or speculate on future price movements.

Futures contracts entitle the owner to delivery of the underlying asset at the agreed-upon price at expiration of the contract. Futures are used by individual traders to speculate on different asset prices, but also by companies and institutions to mitigate risk if they’re exposed to the underlying asset.

How Do Futures Contracts Work?

Futures contracts are sold on exchanges like stocks and options. All contracts have a buyer and a seller. The seller agrees to deliver the asset while the buyer agrees to purchase at the price specified by the contract. The contract will be dated by the month, which is also known as the delivery date. The price of the agreement is known as the forward price.

Futures are purchased on margin, so the buyer only needs to produce a percentage of the capital required to open the position. For example, an oil futures contract might trade at $85 for the November 2024 delivery date. But this contract isn’t just for a single barrel of oil. Oil futures traded on the NYMEX exchange are for 1,000 barrels per contract, so a single contract is worth a position of $85,000 if the market price is at $85.

But thanks to margin, the buyer doesn’t need to pony up the full amount just yet. Margin rates depend on the broker you use and the date of the contract you purchase, but you could open this $85,000 position with as little as $5,000 to $6,000.

To accept delivery, you’d need the full amount of the position. But what would you do with 1,000 barrels of oil? For the speculator, nothing. Speculators and traders of futures will sell the contract before the delivery date, or settle the agreement in cash if such an arrangement is permitted. Most futures contracts can be settled in cash, so you don’t need a warehouse to store your oil or gold should you be forced to take delivery.

Speculators aren’t the only investors who trade futures. Futures contracts can be excellent hedging instruments for companies exposed to the price of the underlying asset. Futures are used to “lock in” the price of a specific asset like oil or coffee so producers and distributors aren’t caught off guard by sudden price gyrations. 

Capital consuming industries like oil and gas drillers often depend on futures contracts for stability in their business plans. For example, finding an oil patch, drilling the raw product and refining the crude into usable oil can take months or even years to complete. What happens if oil is priced at $85 at the start of the operation but plunges to $55 by the time drilling is complete? Without futures contracts, the drillers would have a large gap on their balance sheet as the oil they spent months extracting is now worth 35% less than anticipated. 

Futures contracts can be sold for a profit or loss at any time before the delivery date, which is how speculators make money from them. Buying or selling futures contracts is a ‘bet’ on the direction of an asset price without actually owning the asset in question.

Benefits of Futures Contracts

Futures contracts offer specific benefits to specific investors and entities. Here are a few of the pros to consider:

Hedging Against Price Fluctuations

Futures contracts enable businesses and investors to secure prices for commodities or assets, which helps safeguard against unfavorable price changes. This is especially useful for companies relying on raw materials, as it aids in managing budget estimates and minimizing risk exposure.

Leverage

Futures trading enables participants to manage a large position with a smaller amount of capital due to margin requirements. This allows investors to increase their potential returns, making it an appealing choice for traders who want to enhance their investment strategies.

Liquidity

Futures markets usually offer good liquidity, enabling participants to quickly enter and exit trades. This is beneficial for trading because it helps ensure there are enough buyers and sellers to complete transactions without causing large price changes.

Diversification

Futures contracts allow investors to access a range of asset classes, including commodities, currencies, and stock indices. This diversification can help control overall portfolio risk and improve potential returns by engaging with markets that may act differently than traditional investments like stocks and bonds.

Price Discovery

Futures markets are important for figuring out prices, as they offer insights into supply and demand. The prices set in these markets indicate anticipated future prices, which can help businesses and investors make informed choices based on present market conditions.

Leverage Risks

Futures contracts use a considerable amount of leverage, which can increase profits as well as losses. Traders have the potential to lose more than their initial investment if the market goes against them.

Drawbacks of Futures Contracts

Of course, like any investment, futures contracts bring their own drawbacks. Here are a few of the cons associated with futures:

Market Volatility

Futures contract prices can fluctuate significantly due to several factors, including economic reports, weather conditions, and geopolitical events. This unpredictability may result in sudden and substantial changes in value, raising the risk for investors.

Obligation to Buy/Sell

In futures contracts, the buyer is obligated to buy the underlying asset, and the seller must deliver it at the contract's expiration. This requirement can pose challenges if market conditions fluctuate or if the trader is unable or unwilling to meet their obligations.

Limited Flexibility

After a futures contract is initiated, modifying the terms or exiting the position can be difficult. Traders are typically committed to their contract until it reaches maturity, which restricts their capacity to adapt their strategy according to market fluctuations.

Margin Calls

Futures traders must keep a minimum balance in their margin account. If the market shifts negatively against their position, they could receive margin calls that ask them to add more funds to keep their position open. If they do not do this, their position may be liquidated at a less favorable price.

Compare Top Futures Brokers

Most major online brokers have reduced stock and ETF commissions to 0, but you’ll still pay a fee to trade derivatives like an options contract and futures contracts. If you’re looking to make futures trades, you’ll need to pay close attention to the fee structure and margin requirements.

Here are a few of our favorite choices:

Futures Markets: Upside and Risk

Futures markets can be enticing since profits can be earned quickly and exchanges trade around the clock during the week. For many traders, futures are the first introduction into leveraged products and margin. However, not every trader has the mindset and temperament to trade these derivatives. 

When leverage is applied, profits and losses are magnified and undisciplined traders could find themselves breaking their own rules in an attempt to recoup losses or keep the gain train going. Always have a plan when trading futures and know where your exit points are to the upside and downside.

Frequently Asked Questions