Stock futures have emerged as a very popular way for investors to make money off of financial markets. Compared to traditional stocks, stock futures are a high-risk, high-reward proposition. You can make tons of money off of stock market futures. Be warned though, if you make a bad investment you could stand to lose a lot of your money.
We don’t mention that in an effort to scare you away, but we do believe in being upfront when it comes to risks. When it comes to trading futures in particular, we recommend using “risk capital.” What is risk capital, you ask? It’s money that you could afford to lose. In other words, don’t put your life savings or kid’s college fund into stock market futures.
What Are Futures? An Introduction
Futures are derivative instruments, meaning their value is derived from the value of something else. When you buy a future, you are basically agreeing to buy something now at an agreed upon price, but the delivery of the good, commodity, or stock, is set at some future point in time.
This is perhaps easiest to demonstrate with commodity futures. Let’s say you’re a major food manufacturer and you need a steady supply of rice for some of your foods. In order to ensure this supply, you can buy rice futures. You are paying for rice but not taking delivery of the rice until a future point in time, say six months from now. The rice seller gets money now, allowing him to fund operations, while the you get a guaranteed delivery of rice in the future.
Commodities are commonly traded on the futures market, but you can also buy a wide range of other futures, including stock futures. What’s common among all futures is that the price is agreed upon now, but the “delivery” date is set at a later date. Since the contract itself derives value from commodities, stocks, or something else, it is considered a derivative.
The Nuts and Bolts of Stock Futures
Selling stocks is obviously a bit different from selling commodities. It’s highly unlikely that you will need to ensure a steady delivery of stocks in the future like a food manufacturer might need rice. That doesn’t mean you can’t trade market futures, however.
Generally, when people use the term stock futures, they are referring to stock market futures. Stock market futures derive their value from a market or index, such as the S&P 500 or DJIA. Basically, with a market future, you can predict which way markets will move in the days and hours ahead. These futures are often very popular in the hours running up to a market opening. That’s because investors can try to predict which way markets will move once markets open.
Confused? Don’t worry, these more advanced financial instruments can be a bit more difficult to understand at first. However, they become easier to grasp with time. Futures basically allow investors to bet on which way markets will move.
Stock Futures Example
Let’s say markets suffer a tough week and lose three percent from opening bell on Monday until closing bell on Friday. Come Saturday, market futures are selling for cheap, meaning most investors are feeling pessimistic about how markets are going to perform in the coming week and beyond. You, however, are convinced that a number of economic indicators due next week will boost markets. Some of the indicators are due to be released just before markets open on Monday (this is pretty common). So you don’t want to wait until markets open to make your move. What to do?
Invest in market futures! Investors very commonly trade futures in the pre-market hours, meaning that you’ll be pick up futures before the economic data is released. Then, when the data is released, if you’re proven right and markets move based on the economic data (which is very common), you’ll be able to collect a tidy profit.
Using Futures For Hedging
Market futures are not used solely for investing opportunities. While many investors like to invest in the futures market due to its profit potential, many others like to invest in it as a form of hedging. Confused by this term? Have you ever heard the term “hedging your bets?” Basically, this means betting on multiple outcomes of the same event, so that you’re protected even if things don’t turn out the way you expect.
When it comes to investing, investors will sometimes hedge their bets. This means that they will use futures to protect their portfolios if things don’t turn out the way they expect.
Let’s put this into an example, so we can make it more clear. Say an investor invests in a bunch of tech stocks. Overall, she is confident that these tech stocks will gain value in the weeks to come, but there are some worries about a potential tech bubble. In order to protect against this bubble, she could short some NASDAQ (a tech heavy index) futures, and if a tech bubble does pop, her NASDAQ futures will produce her some substantial money as markets drop.
Depending on how the investor designed his or her portfolio, it might even be enough to offset the losses. In most cases, market futures will only reduce said losses, but they’re still a great option for reducing risks.
As you can see, futures are a bit complex, but they are also exceptionally useful. So if you’re an investor, make sure you give futures a real close look!