If you’re an investor, you’ve almost certainly heard the term “futures” tossed around before. It’s a common enough of a term that it should be familiar to just about every investor. However, that doesn’t mean you know exactly what it means. That’s why we’re going to take a moment to fill you in on what futures contracts are. We’ll also talk about how they relate to stock markets.
The Futures Contract
So what is a futures contract anyways? A future is a contract between a buyer and seller where both parties agree to buy and sell a specific commodity or good at a pre-determined price with the goods due to be delivered at a specified point in time in the future. In other words, the buyer agrees to pay now, but the seller won’t deliver the commodity until a later date.
Usually, futures are drawn up for commodities, such as oil, corn, soy beans, and other similar goods. These goods are basically interchangeable. One barrel of oil of a certain grade or type is equally as valuable as another barrel of oil that is the same grade or type. Besides commodities, however, stock futures are also very popular these days.
Advantages of futures
Futures have several key advantages for both buyers and sellers. For sellers of commodities, these contracts allow them to raise money before they have produced their goods. A corn farmer can sell corn before it grows, for example, and can then use the money from the sale to buy supplies to grow the corn. For buyers, a futures contract can ensure a steady supply. A gasoline refiner, for example, needs to ensure a steady supply of oil that can be refined.
Futures contracts have an expiration date, meaning the exchange must be conducted on or before that date or the contract itself will become invalid. A contract can either be settled with the delivery of the good in question, or through the cash difference.
Investors figured out that futures offered an opportunity to make money. If you buy oil futures now and prices rise dramatically before the expiration date, you will be able to sell your oil future for a profit. Since most investors don’t want to deal with the hassle of oil deliveries, however, cash-for-difference contracts, which settle all contracts in cash, were created.
The basics of stock futures
As we already mentioned, many futures involve commodities, but stock market futures are also available. With stock market futures, investors are able to speculate on the future prices of stock markets through the purchase of stock futures.
The most widely traded future is an S&P future, though Dow Jones futures and NASDAQ futures, among others, are also very popular.
With a stock future, the value of the contract is based on stock indices. If you buy a stock future and the price of the underlying index rises, you will make money. If you short-sell the future and markets drop, you will also make money. Stock futures are thus very similar to investing in regular stocks.
Often, stock futures are used to hedge against risks. For example, if a portfolio manager is worried that markets might trend downwards, but isn’t ready to liquidate his or her portfolio for cash, he or she can use futures to hedge against potential declines. Investing in dow futures and other index based futures will protect the investor against broader declines while also allowing him or her to keep stocks in their portfolio.
Why investors like futures
If you are interested in futures, you don’t have to limit yourself to just stock futures. Many traders prefer futures precisely because they allow people to invest in things besides stocks. Some investors don’t like dealing with stock market data, like company revenues, P/E ratios, and all the rest. Instead, they’d rather look at mega trends, like demand for oil and plastics, weather patterns, and other factors. Futures are one way investors can use mega-trends to invest and make money.
Like every type of investment, futures carry risk with them. In many cases these contracts offer a higher risk profile and more volatility than blue chip stocks. A future based on blue chip stocks, however, can offer a similar, lower risk profile, so keep that in mind. Either way, if you’re looking to invest, you should at least consider futures contracts, in addition to stocks, bonds, real estate, and other investment vehicles.