What Is Futures Trading?

What Is Futures Trading?

Let me explain futures to you directly: they're contracts where you agree to buy or sell a specific underlying asset at a future date. That asset could be a commodity, a security, or some other financial instrument. When you trade futures, you're obligated as the buyer to purchase, and as the seller to sell, that asset at the agreed price, no matter what the market says at expiration.

When people talk about 'futures trading,' they often mean those based on stock market securities. These contracts tie to the future value of a company's shares or an index like the S&P 500, Dow Jones, or Nasdaq. You can trade them on exchanges like the Chicago Mercantile Exchange, and they cover everything from physical commodities and bonds to even weather events.

Key Takeaways

Remember, futures are derivatives—their value shifts with the price of the underlying asset. In stock market futures, you're locked in to buy or sell stocks at a set future date and price. They help hedge against price swings in shares, stock sets, or indexes to avoid losses. Plenty of platforms let you trade them, but you need to know the risks upfront.

How Futures Trading Works

Futures contracts are standardized for quantity, quality, and delivery, so you can trade them easily on exchanges. They bind you to buy or sell a stock or index shares at a fixed date and price, which boosts transparency, liquidity, and price accuracy.

These contracts expire on specific dates, organized by months—like March, June, September, December for something like the S&P 500. The nearest expiration is the 'front-month' contract, where most action happens. If you want to keep your position as it nears expiration, you roll over to the next month. Short-term traders stick to front-month, while long-term ones go further out.

Take index futures like the S&P 500: if you buy a contract, you're agreeing to buy shares at a set price in, say, six months. If the index rises, your contract's value goes up, and you can sell it for profit before expiration. Selling works oppositely—if you think it'll fall, sell the contract, and if it does, buy it back cheaper to pocket the difference.

Tip on Settlement

Settlement varies by asset: commodities like oil or gold usually mean physical delivery. But for stock or index futures, it's cash settlement—no physical handover.

Underlying Assets

With futures, you lock in the asset's price ahead of time, with known expiration and price. Stock futures expire monthly. Underlying assets can include equities based on stocks or groups, stock indexes like S&P 500, commodities like oil, gas, corn, wheat, cryptocurrencies like Bitcoin or Ethereum, currencies like euro or pound, energy like gasoline or heating oil, interest rates for Treasurys and bonds, or precious metals like gold and silver.

Important Note

As the buyer, you must take possession at expiration, not before, but you can sell your position earlier. Futures differ from options—American-style options let you exercise anytime before expiration without obligation, unlike the binding nature of futures.

Speculation

Futures let you speculate on commodity prices. Buy a contract, and if the price rises above your contract price at expiration, you profit. But if it drops, you lose. You can sell the long position before expiration at the current price to close it.

You can also go short if you expect a price fall—offset by buying back later. Profit if the asset's price is below your contract price at expiration, loss if above. It's risky: say the S&P 500 is at 5,000, contract worth $250,000 ($50 per point). With 10% margin, you put down $25,000. If it falls 10% to 4,500, contract value drops to $225,000, wiping out your margin—100% loss.

Hedging

Use futures to hedge against price moves in underlying assets, aiming to prevent losses from bad changes, not to speculate. Say you manage a $100 million portfolio tracking the S&P 500 and worry about volatility. Hedge with S&P 500 futures: at 5,000 points, each contract hedges $1,250,000 ($250 per point). You need about 80 contracts to cover $100 million.

If the index drops 10% to 4,500, portfolio loses $10 million, but futures gain $10 million (500 points x $250 x 80), offsetting it. If it rises, futures lose but portfolio gains—acceptable for hedging against downside.

Advantages and Disadvantages of Futures Trading

Futures involve leverage—you post initial margin, a fraction of contract value, based on size, your credit, and broker rules. They're great for hedging volatility, helping companies budget and protect profits. But drawbacks include risking more than your margin due to leverage.

Regulation of Futures

The Commodity Futures Trading Commission (CFTC), a federal agency from 1974, regulates futures to maintain price integrity, stop abusive practices, fraud, and oversee brokerage firms.

Frequently Asked Questions (FAQs)

Why trade futures over stocks? High leverage lets you control big assets with little capital, though riskier. Markets are nearly always open, so you can trade anytime and react to events.

Which is more profitable, futures or options? It depends on your strategy and risk tolerance. Futures offer higher leverage for bigger profits if right, but higher risks. Options limit losses with nonbinding contracts.

What if you hold until expiration? For equities, it's cash settlement—you pay or receive based on asset change. Sometimes, though, it means physical delivery of the asset.

The Bottom Line

Futures are tools for speculating on prices or mitigating market risks, but they have downsides like potential extra losses if hedging goes wrong, and daily settlements can cause big value swings between sessions.