Stock futures are financial contracts where a buyer and seller agree to a stock transaction at a set price and date in the future. On the specified date, or expiration date, the seller is obligated to sell the stock, and the buyer is obligated to purchase the stock at the stated future price regardless of the current market price. These contracts allow buyers to purchase stocks at lower prices and sellers the opportunity to sell stocks at higher prices. Since future prices are theorized, there is less risk of unfavorable price changes during the time of the contract.
- Stock futures are contracts stating the buyer and seller are obligated to purchase or sell at a future date at a predetermined price agreed upon by both parties
- Stock futures give investors the ability to theorize the path of the given financial instrument, commodity, or security
- Stock futures can be used to hedge a price movement to avoid adverse price changes of a stock
What Are Stock Futures?
Stock futures or futures contracts provide traders the ability to lock the price of a stock. Stock futures have a set price and set expiration date that is known by both parties from the beginning of the process. Often, an expiration month is used to identify futures. For example, if you see a January stock future, you can assume the future expires in January. The term future is representative of the market overall, so many different kinds of futures contracts exist including:
Stock Index Futures (S&P 500)
- Current futures (British Pound, The Euro)
- Commodity futures (wheat, natural gas, corn, oil)
- Precious metal futures (gold, silver, platinum)
- The U.S. Treasury futures (bonds)
It’s important to recognize the difference between futures and options. Unlike options where each party can exercise the option, both parties are obligated to complete the transaction according to the predetermined terms with futures.
Advantages and Disadvantages of Stock Futures
As with anything in life, stock futures have both advantages and disadvantages associated with them. When deciding if entering into a stock futures contract is right for you, it’s important to carefully consider both the pros and cons that come with it.
Advantages of Stock Futures
- Stock market futures may be cheaper with a deposit only a fraction of a broker’s contract amount
- Trades may use stock futures for speculating the direction a stock’s price may take
- Companies can use futures to hedge the price of products they’re selling or raw materials to protect themselves from negative price movements
Disadvantages of Stock Futures
- Margins can be a double-edged sword as both gains and losses can be amplified
- Companies attempting to hedge by investing in a stock futures contract may miss out on profitable price movements
- Traders risk losing more than the original margin amount since stock futures utilize leverage
Using Stock Futures
High leveraging is usually involved with stock futures, meaning the investor doesn’t need to deposit the entire amount of the futures contract’s value when going into the trade. Instead, an initial margin amount is required by the broker equal to a portion of the total value of the contract. The amount a broker holds often varies, dependent on things like their terms and conditions, the investor’s creditworthiness, and the contract size.
The specific exchange where the trade happens determines if the futures contract can be cash-settled or if it is for physical delivery. Typically, futures contracts involve investors speculating on the trade. This type of futures contract is netted or closed out with the difference between the closing trade price and the original trade, and then cash-settled. Corporations may enter into physical delivery contracts to lock in, or hedge, the price of a particular commodity needed for production.
Stock futures contracts allow investors to speculate about the direction of a stock’s price. If an investor buys a stock futures contract, the price of the stock rises, and if at expiration is selling for more than the price state in the original contract, the investor makes a profit. Prior to the expiration date, the long position or buy trade would be unwound or offset with a sell trade for an equal amount of the current price, essentially eliminating the long position.
The price difference between the two contract prices would then be cash-settled in the trader’s brokerage account with no physical product exchanging hands. It is, however, possible for the trader to suffer a loss if the stock’s price is less than the purchase price stated in the futures contract.
Speculating investors can also sell speculative positions or take a short if they anticipate the value of a stock will decrease. If the stock’s price does fall, the investor will receive an offsetting position to terminate the contract. The net difference is again settled at the contract’s expiration. If the stock’s price falls below the initial contract price, the investor will notice profit. If the contract price is below the current price they will see a loss.
Investors need to remember that margin trading allows for a more significant position than the actual amount in the brokerage account. This means margin investing may increase gains, but can also amplify losses.
For example, say an investor has a $2,500 balance in their broker account and is trading for a $25,000 position in petroleum. If the price of petroleum moves against the trade, the investor may incur losses far exceeding their account’s $2,500 original margin amount. If this happens, the broker makes a margin call and requires additional money to be deposited into the brokerage account to cover the loss.
Futures contracts allow the movement of a stock’s price to be hedged. The goal in doing so is to decrease the chances of a loss from any possible price changes that are unfavorable to the futures contract. Many corporations will go into hedges due to producing or using the underlying asset.
For example, crop sales clerks may use futures to lock-in a set price to sell their product. In doing so, they decrease their risk in addition to guaranteeing they will get a fixed price. If their crop’s price decreases, they gain on the hedge to offset any possible losses of selling the product on the market. The gain and loss offset is responsible for locking in an agreeable market price.
The Commodity Futures Trading Commission (CFTC) regulates stock market futures. Created by Congress in 1974, the CFTC is a federal agency charged with ensuring the pricing integrity of the stock futures market. This includes the regulation of brokerage firms engaging in stock futures trading as well as preventing fraud and abusive trading practices.
Futures Real-World Example
Say an investor wants to speculate on the price of oil stock by entering into a stock futures contract in June with an expectation that the stock’s price will be higher by the end of the year. The December stock futures contract is trading at $100, and the investor locks in the contract.
Since oil is traded in increments of 1,000 barrels, the investor has a position worth $100,000 of oil (1,000 x $100 = $100,000). The investor, though, will only be required to pay a portion of that amount at the beginning, known as the initial margin, which is deposited with a broker.
From June until December, as the price of oil fluctuates, so does the value of the futures contract. If the price of oil gets too volatile, the broker will likely ask the investor to deposit additional funds into the margin account.
As the third Friday of December approaches, or the ending date of the contract, one of two things will happen:
- If the price of oil has increased to $175, the investor may sell the original contract and exit the position. They cash-settle the net difference, and they earn $75,000 minus any broker commissions and fees. ($175 – $100 = $75 x 1,000 = $75,000)
- If the price of oil has decreased to $85 the investor loses $15,000
($85 – $100 = $-15 x 1,000 = $-15,000)