Futures 101

A Guide to Investing In Futures

Futures 101
January 7, 2014

Futures are a type of financial contract where two parties agree to a future transaction at an agreed-upon price. That transaction could be in commodities, currencies, stock indexes or other goods.

Futures contracts contain all the pertinent transaction details — quantity, specifications, price per unit and intended delivery method. However, many futures contracts do not result in an actual exchange of goods. Instead, the contract is used to meet a financial objective.

There are two main reasons to invest in futures — speculating on prices for profit, or hedge pricing to minimize risk.

Hedging is a means of protecting against unfavorable price increases. The classic example uses a commodity like wheat. If wheat prices are favorable well before harvest time, a futures contract can guarantee the current price when your crop is harvested. The gain or loss on the market price offsets the gain or loss on the futures contract. The intent is to have a more predictable price (and income). While we are discussing commodities here, the principle is the same for stock indexes or other goods.

Futures traders also use a strategy known as spreads, another form of risk hedging that involves holding two contracts of the same commodity. They could differ by the delivery date, the exchange on which they are created, and combinations of long and short positions.

Speculators generally do not intend to deliver or receive the goods in question. They are following the classic "buy low, sell high" philosophy where the intent is to profit from the price differential.

  • If you are the seller, (deliverer of goods), you have the "short" position, and are betting on prices to fall or locking in a commodity price you intend to sell in the future.

  • If you are the buyer, (receiver of goods), you have the "long" position and are betting on prices to rise or guarding against rising prices if hedging.

Futures for short-term investment are often purchased on margin, which is in essence a loan from your broker that increases your buying power. However, just like a credit line at a casino, this allows you to overextend yourself easily. Losses may drop below your minimum account balance, triggering a margin call that requires an immediate deposit of funds or selling of stock. Buying longer-term futures on margin requires a higher rate of return to cover accrued interest, therefore decreasing your chances of profit.

You can buy futures through brokers — some specialize in the futures market. Full-service brokers provide more services at higher cost; discount brokers charge less but provide less. Thoroughly research brokers and understand their fees and services before making your decision.

Futures exchanges include the Chicago Board of Exchange, CME Group, Intercontinental Exchange, New York Mercantile Exchange, and regional exchanges like the Kansas City Board of Trade and the Minneapolis Grain Exchange. Most have specific areas of expertise.

Other important notes:

  • Futures contracts have expiration dates. Therefore, you run the risk of holding a future contract you do not want, but can't sell. You are legally bound to follow through on the transaction.

  • Futures have daily price limits to keep markets stable — typically, the closing price of the previous day with a tolerance per unit to be added or subtracted.

  • Trading in futures requires significant investment. A typical minimum investment with a broker is $5,000, and it takes significantly more to comfortably op
  • erate and allow for potential losses.

Futures provide the opportunity for unlimited returns while posing the risk of unlimited loss. Consequently, they are not for amateurs or those who can't afford substantial losses.

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