What are futures?
A futures contract is an agreement to trade something at an agreed upon price at a date in the future. The underlying security can be a commodity (like oil, gold, or agricultural products), a stock index, or currency. The buyer of a future agrees to buy a certain quantity of the underlying asset at a set date, while the seller agrees to sell it to them at that price by that date.
As an investor, the buyer hopes that the price of the underlying asset increases in value, so the future will allow them to get it at a below-market price. Conversely, the seller hopes it will fall in value, so the contract will allow them to sell it for an above-market price. Futures trading is similar to options trading in that they are both contracts between two parties with expiration dates, but otherwise operate very differently.
The different futures underlyings
In the mid-1800s, farmers – who planted crops and sold their harvests at the end of the season – wanted certainty about what prices they'd get. With the introduction of futures, a corn farmer could lock in a sale price three months away without having to worry about what changes may occur to the price of corn in that time. These days, one can invest in futures contracts for a wide variety of goods, including metals (like gold, silver, and copper) and oil.
Since there are many futures traders who have no interest in taking delivery of vast quantities of oil or corn, most traders close or roll over their futures position before it officially expires. In some cases, you'll be able to find a futures contract with an expiry date as far as 10 years from now. However, many traders seek futures expiring within three months, since there is more trading activity in the months leading up to the expiration date – making them easier to trade.
Some futures don’t even involve any physical goods. Some use stock indices like the S&P500 as their underlying asset. When the expiration date comes around, the two parties simply settle the difference between the future price and the S&P500’s value with cash.
Components of a futures contract
Every futures contract has two key details that need to be identified before trading:
- Contract size (multiplier): Each futures contract has a quantity of the good in question that must be delivered to the end buyer by the expiration date. Depending on the underlying asset, this could be as few as 50 times the index value for an S&P500 index future, or as much as 5,000 bushels of corn. To make things easier for retail traders, brokerages have created ‘e-mini’ and ‘micro’ contracts, which are a fraction of the original future’s size. For example, a standard oil futures contract is for 1,000 barrels, whereas an e-mini contract is for 500 barrels and a micro contract is only for 100 barrels. Make sure you’re getting the right one!
- Expiration Date: When a futures contract expires, the seller must deliver the underlying good to the buyer – if there is one. In the case of cash settled futures, the money will exchange accounts that night. For futures contracts with physical deliveries, it’s typical for the buyer to receive the underlying within the following month.
Trading hours
Most futures contracts trade 24 hours a day with a one-hour gap between 5pm ET and 6pm ET. On Saturday, futures markets are closed, so trading stops at 5pm ET on Friday and reopens at 6pm ET on Sunday.
Since futures markets open on Sunday, investors will often look to see how index futures are performing as an indication of what may happen on Monday morning when the stock markets open.
Trading futures: the details
Futures trading can only be done in a margin account (for more on how these work, see our explainer). When trading futures, you are taking on the obligation to buy or sell a large quantity of the underlying thing. For example, if you buy an oil futures contract, you are agreeing to buy 1,000 barrels of oil. If the price of each barrel is $82, then on expiration, you are expected to spend $82,000.
Related: "How margin accounts work: a guide"
You do not, however, have to have $82,000 in your account. For futures contracts, most brokerages require investors to have between two and 12% of the full price in their accounts. The rest will be offered as a loan. In this case, you would only need to have approximately $7,000. This margin requirement exists to ensure that you and your brokerage don't take on too much risk.
If oil does start to decrease in value, your brokerage may issue you a margin call requiring you to add more funds to your account to satisfy the margin requirement. If you do not add funds, they may close your futures position to prevent further risk.
If the opposite happens, and the price of oil increases, that is good for your futures position, since you now have a contract saying you can buy oil for cheaper. To allow you to capitalize on this immediately, your account will be credited with that profit amount, allowing you to use it on other purchases. This process of adjusting your balance at the end of every day is called mark to market.
One of the key benefits of futures trading is that you are able to get exposure to a large position due to the contract size, while requiring a much smaller initial investment. This is a double-edged sword, however: while it may grant you larger profit, it can also mean greater losses.
Summary
Futures trading is an agreement between a buyer and seller to trade an underlying security at an agreed upon price in the future. Futures can be closed early to prevent the buyer from actually taking delivery of the underlying asset. Any movement in the underlying price constantly adjusts your account balance based on the difference between the current price and your agreed upon price. Trading futures requires a margin account, and each contract reserves a portion of your funds, called a margin requirement. Futures trading is available almost 24 hours a day on every day on weekdays.
