What are Futures?

Are you already investing in stocks and thinking of diversifying into futures trading? Or is there a commodity or index you want to buy or sell? Learn more in this introduction to futures.

What are futures in the market?

Futures are the name given to a type of financial contract where an agreement is made to buy or sell an asset at an agreed price in the future.

Huh?… OK That was the technical definition.

What you really need to know is that futures are the go-to way to do day trading in almost anything that is not a stock. Be it energy markets, agricultural commodities, bonds, stock indices or even cryptocurrencies to name just a few.

The general game plan for trading in futures is the same as all financial markets (buy low / sell high!). But there are some details to get familiar with.

Popular types of futures

Futures traders will typically go through futures exchanges like the Chicago Mercantile Exchange (CME) or New York Mercantile Exchange (NYMEX) or London Metal Exchange (LME).

TYPES	POPULAR EXAMPLES
Commodity futures	Metal futures – gold, silver, copper, platinumEnergy futures – crude oil, Natural Gas, Heating oilGrain futures – corn, wheat, soybeansLivestock futures – Live cattle, Lean hogsFood & Fibre futures – coffee, cotton, sugar, orange juice
Financial futures	Index futures – E-Mini S&P 500, E-Mini Nasdaq, Mini Dow JonesBond futures – US 10-Year notesMoney market futures – Eurodollars, Federal Funds
Currency futures	Euro, Swiss franc, British pound, Japanese yen, Canadian dollar (all priced in US dollars)

Why futures are called ‘futures’

The word ‘future’ can be a source of confusion and leads to questions like ‘Do futures predict stock market?’. It is important to understand that the price of the futures contract now is not necessarily what the price of the underlying asset will be in the future.

The price of the futures contract represents what the overall market thinks the asset is worth at the current moment. Investors will buy the futures contract in the bet that it will be worth more when it expires (in the future) or sell it in a bet that they think will be worth less in the future.

The word ‘future’ is used because the agreement is to buy or sell an asset at a specific price in the future.

How do futures work?

For those familiar with the stock market, a natural question is ‘Are futures the same as stocks?’ This is understandable because stock traders will watch index futures for a read on how the actual stock index will open, asking the question ‘What are futures doing today?’. Futures on the S&P 500 are some of the most widely-watched even by stock market and forex traders.

There are some similarities in that both stocks and futures are typically traded on an exchange, and both use a standardised contract. The primary difference is that rather than trading in your ownership of shares in a company, futures involves trading a contract about possible future ownership.

Example futures trade

At this stage let us give a basic example of what a futures trader might be trying to achieve (we will build on it later with more detail)

Let us say a trader buys an August Mini-gold futures contract (symbol MGC).

They are saying that they agree to buy 100 troy ounces of gold when the contract expires in August.

If the trader is still holding the contract at the expiry of the contract, they will have the choice of taking delivery of the physical gold or taking delivery of the US dollars the gold is worth at the time of expiry. Most traders will take the cash delivery because storing physical gold is costly and difficult to manage.

However, they do not have to hold onto the contract until expiration, they can sell the futures contract and buy back an equivalent one again as many times as they want until expiration. That is why futures trading lends itself well to day trading.

Why trade futures markets

Now we have got a basic understanding of how futures work, let’s go through why you might take the next step of actually trading futures in your investment account.

Access to different markets

A truly diversified portfolio needs to encompass different asset classes, not just different kinds of equities. The typical 60/40 portfolio will divide up your investments into stocks and bonds but that misses out a huge number of available markets. Hard and soft commodity markets from gold and silver to corn, wheat and oil have been traded through futures markets for decades.

Leverage

Most asset classes can be traded via ETFs as an alternative investment vehicle to futures. A distinct advantage futures have over ETFs is leverage. Futures contracts will typically use a leverage ratio of 10:1, meaning $1 of margin collateral is needed to trade $10.

NOTE: Using leverage also increases risk because moves in price will cause bigger than usual swings in profit or loss on the trade.

Hedging portfolios

A classic example is that if you own stocks on a certain market, for Example Swiss investors own some domestic Swiss stocks. If they were worried the broader market was due a correction, they could hedge their portfolios by selling Swiss index futures (FSMI on the Eurex exchange).

Liquidity

Trading futures is nothing like trading penny stocks, the most popular futures contracts trade in the hundred of millions of dollars each day in trading volume. This deep liquidity means you will almost always be able to buy and sell at the price you want.

Avoid swaps or overnight charges

A disadvantage of trading forex or CFDs is the overnight funding charge. This charge happens because these are spot contracts with a 2-day expiry that need to be rolled over and incur a charge when doing so. Futures, where the expiry is set some time in the future incorporate any fluctuations in interest rates etc into the price, so no extra fees are involved.

Trade in rising and falling markets

Macro hedge funds, who are professional futures traders, take advantage of situations when the price is rising and falling. As a futures trader you can do the same. If you believe the price of crude oil will go lower in the next month, you can just as easily sell a crude oil futures contract as buy one, putting you short the market.