A Bacon Illustration
The best way to think about how stock market futures work is to understand a tangible application of a basic futures transaction. Let’s assume you are a meat packer and you sell bacon and you need to buy pork bellies to make your product. Every day, the price of pork bellies goes up and down based on various market conditions. You would like to buy the pork at the lowest price possible so you can make the largest profit when you sell your packaged bacon. Realizing the price of pork bellies in 6 months may be very different from the price of pork bellies today, you enter into a stock market futures contract with a farmer to buy his hogs at a prearranged price on a future date.
Knowing that the farmer also needs to make money, it is not realistic for him to agree on a price well below current market value allowing you to maximize profit. The two of you come up with a transactional agreement that will allow both of you to make a profit in six months. The agreed price will not be at the top or bottom of the price range, but will be a fair price that protects both of you from extreme market fluctuations.
Stock Market Basics
Stock Market Futures work in much the same way. Two sides enter into an agreement to buy or sell a specific amount of stock for a certain price on a future date. The main difference between tangible commodities like corn, wheat or feed cattle and stock futures is that stock futures are almost never held to expiration date but instead are bought and sold on the futures market exchange at their current perceived value.
Stock Futures Vs. Stock Certificates
Buying or selling a stock future is very different than buying a stock certificate in many ways… The main difference is that you are not buying the stock certificate itself , you are entering into a contractual agreement to buy or sell a stock certificate at a specific date and price. And unlike stock ownership, you have no rights to shareholder meetings or dividends because you do not actually own the stock. The two main advantages of stock market futures have to do with the use of margin and the ability to make money on either the buying or selling side. If you think the price is going to be higher in the future you would want to buy or go long. If you think the price is going to be lower you would want to sell or go short.
An Apple Example
Let’s look at an example of Apple Inc. Let’s say Apple is trading at $550 and you thought the stock was to appreciate in 6 months to $575. If you bought 100 shares for $55,000 and the price moved to your expected value of $575 you would stand to make $2,500. The difference between $57,500 and $55,000, roughly 4.5% profit. However, you could do the same transaction by using a stock market futures contract at a fraction of the cost by using margin.
Margin may be anywhere between 10 to 20 percent of the price of the contract. So if you were looking to do a 6 month futures contract on Apple at 20% margin your original investment would only be $11,000 versus the stock certificate that was $55,000. In the above scenario, you would still earn $2,500 if the stock price moved to $575 per share but your resulting stock futures contract profit would jump to a dramatic 22.7%.
Margin cuts both ways. If the price had fallen $25 on the original stock you could also stand to lose the same $2,500 which would be a 22.7% loss. Please note that if you are buying on margin your broker could issue a margin call if the value of your investment falls below the contracts maintenance level. The maintenance level is predetermined by your broker based on the price and volatility of the contract being traded.