Stock Market 101: Futures

Overview:

1. What are Futures?

2. Pros and Cons

3. Regulation of Futures

What are Futures?

Futures are essentially financial contracts obligating the buyer to purchase an asset or the seller to sell an asset and have a predetermined future date and price. Futures—also called futures contracts—allow traders to lock in the price of the underlying asset or commodity. These contracts have expirations dates and set prices that are known upfront. Futures are identified by their expiration month. For example, a December gold futures contract expires in December. The term futures tend to represent the overall market. However, there are other types too such as stock index futures and currency futures. The futures markets typically use high leverage. Leverage means that the trader does not need to put up 100% of the contract's value amount when entering into a trade. Instead, the broker would require an initial margin amount, which consists of a fraction of the total contract value. The amount held by the broker can vary depending on the size of the contract, the creditworthiness of the investor, and the broker's terms and conditions. A futures contract allows a trader to speculate on the direction of the movement of a commodity's price. Futures can be used to hedge the price movement of the underlying asset. Here, the goal is to prevent losses from potentially unfavorable price changes rather than to speculate. Many companies that enter hedges are using—or in many cases producing—the underlying asset.

Pros and Cons

Pros

• Investors can use futures contracts to speculate on the direction in the price of an underlying asset

• Companies can hedge the price of their raw materials or products they sell to protect from adverse price movements

• Futures contracts may only require a deposit of a fraction of the contract amount with a broker

Cons

• Investors have a risk that they can lose more than the initial margin amount since futures use the leverage

• Investing in a futures contract might cause a company that hedged to miss out on favorable price movements

• Margin can be a double-edged sword meaning gains are amplified but so too are losses

Regulation of Futures

The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market pricing, including preventing abusive trading practices, fraud, and regulating brokerage firms engaged in futures trading. 

KeyPoints:

1) Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset and have a predetermined future date and price. 2) A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument. 3) Futures are used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.