Not every financial transaction is—or even needs to be—completed in the here and now. Sometimes, investors or companies want to buy or sell something at some point down the road. This is done for a variety of reasons, which can range from trying to profit from changing prices or its complete opposite—to guard against an adverse swing in prices.
One of the most common ways to do this is known as a futures contract. A wide market exists for investors—mainly big asset managers and corporations—to enter into these agreements and to buy and sell them. “It’s fair to say that futures are the playground of professional and institutional traders,” says Titan strategist Myles Udland.
What are futures?
The term “futures” is shorthand for a futures contract, and a futures contract is simply an agreement to buy or sell something at a future date, for a quantity and price agreed upon now. Investors usually use futures either to protect against price swings, a strategy known as hedging, or to exploit price swings, called speculation.
Futures are financial derivatives because their value is derived from some underlying asset. The asset can be physical—a bushel of wheat, a barrel of oil, an ounce of gold—or it can be financial, such as shares of stock, a bond, a currency or indexes of these and other assets.
Futures were first used in agriculture for farmers to get a guaranteed price for their crops—to hedge against the risk of lower prices at harvest time—and eventually expanded into other natural-resource markets such as energy and metals. The futures market was conceived as an alternative to the spot market for immediate payment and delivery of a commodity or other asset.
An example of futures
Imagine a wheat farmer wants to get a decent price for their crop—say $8 a bushel—but is concerned that wheat prices could decline in the next few months, when the crop will be ready. Wheat was trading at about $7 a bushel one month earlier, but lately it has risen to almost $8.50.
At the same time, a commodities trader for a hedge fund is willing to bet the other way—that wheat prices will surge in the next few months, to $9 a bushel or higher.
This is where the farmer and commodities trader come together. The farmer sells a futures contract for $8 a bushel to guard against the possibility that wheat will fetch less than that at harvest time. The trader buys the contract at $8 hoping that wheat will climb to $9, profiting from the difference.
In futures parlance, the farmer is the hedger, seeking to guard against the risk that wheat prices fall. The commodities trader is the speculator and anticipates that prices will rise, and is thus willing to take on the risk the farmer wants to avoid.
Futures can also bring two hedgers together. The wheat farmer could sell $8-a-bushel futures to a flour miller, or a cereal maker. The farmer locks in a price of $8, and the miller or cereal maker hedges its raw-material cost at $8, avoiding the risk that wheat prices rise on the spot market.
Futures change hands on futures exchanges, with standardized contracts for size and quality of assets, which makes trading easier. The two biggest exchanges in the U.S. are the Chicago Mercantile Exchange and the Atlanta-based Intercontinental Exchange. Contracts have a quarterly life cycle, typically expiring in March, June, September and December.
Futures vs. options: Key differences
Futures and options are both derivatives, but they differ in several ways.
Futures are linked to an array of markets including commodities, stock indexes, bonds and currencies. Options are mostly about stocks.
Obligation to complete the contract
Futures require buyer and seller to complete the contract at expiration, either by the buyer’s full payment and the seller delivering the asset, or by cash settlement of the difference between the futures price and the asset’s spot market price. Buyer and seller each have an obligation.
Options, by contrast, give the buyer the right, but not the obligation, to complete the contract by exercising the option. A buyer can choose not to exercise the option if the exercise price is not profitable, or sell the option to another investor before expiration.
Futures require a margin, a good-faith payment to establish the futures position. Typically the margin amount is about 5% to 10% of the contract value. A futures contract valued at $100,000, for example, might require the investor to put up $7,000 as initial margin and maintain a minimum of $6,000 in the margin account while the futures contract is open.
Options require the buyer to pay only a fee, called an option premium, for the right to buy or sell shares of stock at a predetermined price. Options are typically for 100 shares, so if the premium is $3 per share, for example, the buyer of a call option pays $300 for the right to call (buy) 100 shares at the exercise price. The option seller collects the per-share premium, and is only required to sell the shares if the buyer exercises the option.
Investors and market size
Futures trading is mainly for institutional investors because the contracts are large, typically $100,000 or more, margin payments are substantial, and institutions often have warehouses and other facilities if they choose to take physical delivery of commodities. Options are more accessible to smaller investors because the dollar amounts involved generally are smaller.
In 2021, global trading in futures and options increased 34% to almost 63 billion contracts, with futures accounting for almost half the total, according to the Futures Industry Association, a trade group based in Washington, London, and Singapore.
The dollar size of the futures market depends on whether the measurement is of the notional value—or leveraged value—of all contracts, which is many trillions of dollars, or the smaller market value of contracts—the amounts investors have actually staked through margin accounts. This is still many billions of dollars.
6 types of futures
Key kinds of futures include:
- Commodities: corn, wheat, soybeans, and livestock, as well as coffee, sugar, cocoa, orange juice as well as other agricultural products.
- Energy: predominantly crude oil and natural gas. Other energy futures include gasoline, heating oil and jet fuel.
- Metals: gold, silver, platinum for precious metals; aluminum, copper, and steel for industrial metals.
- Equities: these are mainly linked to stock market indexes, not individual stocks, where options predominate. Futures for the Standard & Poor’s 500 Index are among the most popular. Other futures are based on the 30-stock Dow Jones Industrial Average and the Nasdaq 100 index.
- Bonds and interest-rate instruments: these futures are mainly for government bonds, especially U.S. Treasury bonds, and eurodollars, which are interest-paying dollar deposits in banks outside the U.S.
- Currencies: the most popular currency futures are for the dollar-euro exchange rate, dollar-yen, and euro-yen. Futures also are available on the dollar index, a trade-weighted measure of the dollar’s value against six major currencies. Bitcoin now has futures trading as well.
Potential benefits and risks of futures
Futures offer investors a number of potential benefits:
- Ability to hedge. Companies can hedge the price of their raw materials by buying futures, while commodity producers can sell futures to hedge against the risk of falling spot prices. Each gets peace of mind by locking in a price.
- Leverage. Leverage is employed through margin accounts that require pledging only a fraction of the futures contract’s value, offering the potential for outsized gains if a trader bets correctly on the asset’s price direction. The good-faith money pledge is called margin.
- Ability to speculate. Investors can speculate on price trends in the underlying assets, without having to buy the assets upfront. For example, for only a $5,000 margin payment, an investor in February might purchase a $200,000 futures contract for the S&P 500 Index, pegged at an index value of 4,000 and expiring in June, at a time when the index is at, say, 3,900. The investor is betting the S&P 500 will be above 4,000 by June when the contract expires, profiting from cash settlement of the amount above 4,000.
There are, however, some significant drawbacks to futures:
- Risk. Leverage means risk. While this can magnify trading gains if the price bet goes the speculator’s way, it can magnify losses if the price goes the other way. The hedger also faces an opportunity risk: the possibility of either paying too much only to see the asset’s spot price subsequently decline, or selling too cheaply only to see spot prices rise.
- Fluctuations in margin. Futures are revalued daily to see if an investor’s margin pledge is still adequate; if not, the futures exchange will demand more money from the trader to replenish the margin account.
The bottom line
Futures can be useful in hedging the risk of price volatility in the underlying assets, such as oil, gold, and stock market indexes. They are also a way for investors to take that risk by speculating on the direction of asset prices. But they are primarily for investment professionals, not small investors, because of the size of futures contracts, the amount of margin money required to access futures trading, and the use of leverage that can result in big losses as well as big gains.