Definition:
A futures contract is an agreement to buy an asset at a specified price and quantity at a future date. Futures contracts are used by companies to hedge risks, and they are used by traders to speculate on the future of a single commodity and the market in general.
How do futures contracts work?
Futures contracts are derivatives that lock in the price and quantity of a commodity, currency, or stock trade in advance. Futures contracts are generally traded on an exchange like the CME Group, where speculators can match with each other and businesses to trade futures contracts.
The specified date in a futures contract is called the expiration date and trades in small units called ticks. Ticks are the smallest price increment for trading and are usually worth one cent. The exception is S&P 500 index contracts, whose ticks are worth a quarter point on the index point.
Note: A futures contract can be settled at expiration either by delivering the underlying asset or in cash, depending on the type of contract you have. For example, stock index contracts are settled in cash.
Futures contracts that trade on an exchange typically have a standard contract size, determined by the exchange, and often have no counterparty risk as the exchange settles all trades.
Why are futures contracts traded?
Business owners typically use futures contracts to hedge risks. For instance, a corn farmer might use a futures contract to lock in a certain price for corn months ahead of time. An airline company might use futures contracts to hedge against rising fuel prices.
Traders can use futures contracts to speculate. Individuals can trade futures contracts using a brokerage account such as Schwab or TD Ameritrade.
Futures trading is known for its leverage. While stock trading typically requires 50% equity, futures contracts can be traded with as little as 3%. This means that for every $1,000 in trade, you only need to put up $30. This level of leverage makes futures trading one of the riskiest investments.
Note: Because futures contracts are highly risky investments, they may not be suitable for all individual investors.
Example of futures contracts
Suppose a soybean farmer is worried about a collapse in soybean prices before harvest and wants to lock in a price for part of the potential crop now. The farmer can use a brokerage account or even the CME Group website to check current offers for various futures contracts (known by the month, so futures contracts due in November will be called November soybean contracts).
If the farmer finds a price that guarantees a sufficient profit, he can sell the contract and deliver the soybeans at the contract date.
Types of futures contracts
Futures contracts can be based on a wide range of underlying assets. Here are some different types of futures contracts:
- Financial futures: Financial futures include stock indices, commodity indices, and U.S. government debt instruments.
- Currency futures: There are many currencies available for trading through futures contracts, including the U.S. dollar, Brazilian real, and digital currencies like Bitcoin and Ethereum.
- Energy futures: Energy futures include crude oil, natural gas, and other petroleum products like gasoline, heating oil, and even ethanol.
- Agricultural futures: These contracts include grains, livestock, food products, and fibers such as wheat, cattle, and coffee, respectively.
- Metal futures: Precious metals like gold and silver, as well as industrial metals like copper, can be traded.
Costs of futures contracts and trading requirements
The costs of trading futures contracts include broker commissions. For example, Schwab charges a fee of $2.25 per transaction. Exchange and regulatory fees are also applied. Exchange fees vary by product, and the regulatory fee is two cents per contract.
Note:
The requirements for trading futures contracts are much more flexible than the requirements for trading stocks. For day traders who trade stocks, there is a minimum margin requirement of $25,000. For futures traders, the typical margin account can be just a few hundred dollars, depending on the type of contract.
Futures Contracts vs Options
Options and futures contracts are derivatives, the difference is the obligation. Futures contracts obligate the seller to deliver on the contract dates. Options agreements give the buyer the right, but not the obligation, to buy or sell the contract by the expiration date.
Alternatives to Futures Contracts
Investors who want to speculate on commodities but do not want to use margin or set up a special account for trading futures contracts can use exchange-traded funds (ETFs) or exchange-traded notes (ETNs) to invest in commodities.
Frequently Asked Questions
What are Dow futures contracts?
Dow futures contracts are contracts based on the Dow Jones Industrial Average. Dow futures contracts can be used to predict short-term stock market movements during market closures or to speculate on market direction in the medium term.
How do you trade futures contracts?
Futures contracts are traded on exchanges like the CME Group through brokers like TDAmeritrade and Charles Schwab.
Source: https://www.thebalancemoney.com/what-are-futures-definition-and-examples-1031172
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