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What are Futures?

definition

A futures contract is a legal agreement between two parties to buy or sell a set amount of an asset at an agreed-upon future date — But the price is set today.

🤔 Understanding futures

If you know you're going to need something in the future, but it's selling for a good price now, you could buy it and store it for later. Or you could use a futures contract. In a futures contract, the buyer and seller make a deal on the price, quantity, and future delivery date of an asset beforehand. When you invest in futures, you can play the role of either a buyer or seller. Buyers hope the price of an asset will go up, sellers hope the price of an asset will go down. Investors can trade futures contracts on all sorts of commodities (like corn, orange juice, or gold) and financial instruments (like foreign currencies or stock indexes) to try to make money from price changes in the market.

example

In 2010, the Chicago Mercantile Exchange created a cash-settled cheese futures contracts. Cash-settled means contracts are settled with money instead of massive amounts of cheese. Traders can guess the future price of cheese without worrying about actually delivering, or receiving, tons of cheese when the contract expires.

Cash-settled cheese futures specify a quantity of 20,000 pounds of cheese at $0.001 per pound, which is equal to $20 per pound. This means that every time the cheese price moves $0.001, the value of the contract moves $20.

Say a trader taking a buyer position and a trader taking a seller position agree on a cash-settled cheese futures contract valued at $1.675 per pound. If the cheese price goes up to $1.676 (a gain of $0.001), the seller loses $20 but buyer wins $20, without even touching a slice of cheese.

Takeaway

Futures contracts were born out of our need to eat...

Long ago, people knew they needed their share of the coming harvest to survive. Farmers wanted to get a decent price for their produce before all the crops were harvested and the market was glutted — driving prices down. Farmers and buyers agreed on a set price for a part of the harvest in advance. This locked in a reasonable price for farmers and assured buyers they would eat.

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Tell me more...

What are futures?
What’s in a futures contract?
What is a futures exchange?
What are margins in futures trading?
How do you close out a futures contract?
How does trading stock index futures work?
How to get started with trading futures
What are the pros vs. cons of futures trading?

What are futures?

Futures contracts and “futures” mean the same thing. Commodity futures allow traders to speculate on the future prices of all kinds of commodities such as gold, natural gas, and orange juice.

Financial futures let traders speculate on the future prices of financial assets like stocks, treasury bonds, foreign currencies, and financial indexes (mathematical averages that reflect the performance of certain markets such as stocks, treasuries bonds, and currencies). There are even futures contracts for Bitcoin (a cryptocurrency).

Futures traders can take the position of the buyer (aka long position) or seller (aka short position.) If the price goes up, the buyer takes profits because he or she purchased the asset at a lower price. If the price of an asset goes down, the seller takes profits because he or she sold at a higher price.

Retail traders aren’t interested in holding a futures contracts until they expire. Traders close out of their contracts when the difference between the contract price and the current market price will make them a profit — or if they’re taking losses and want out.

Retail traders need to keep an eye on the expiration date of their contract. Futures contracts can have settlement methods upon their expiration date that require the actual delivery of an asset rather than a cash settlement.

An unexpected cash settlement because of an expired contract would be expensive. But if you’re long (buyer position) on a futures contract for 15,000 pounds of frozen orange juice with a “deliverable” settlement method and you let your contract expire, you could get a delivery notice telling you where to pick up all that orange sticky goodness.

What’s in a futures contract?

Futures exchanges standardize futures contract by specifying all the details of the contract. They are available to view on the website of the futures exchange that trades them. Contracts specify:

  • Asset traded (oil, corn, Bitcoin)
  • Quantity traded (1000 barrels, 5000 bushels, 5 BTC)
  • The quality of the asset if it’s a commodity (different types of crude oil, for example)
  • Prices (dollars, cents, a fraction of cents)
  • The smallest price fluctuation (how much each tick up or down is worth)
  • Hours you can trade (depends on the asset traded)
  • The expiration date of the contract (aka the Delivery Date)
  • Settlement method upon expiration (physical delivery of the asset or cash settlement)

What is a futures exchange?

Futures are traded on futures exchanges which are like meeting places where futures are bought and sold. Different futures contracts trade on separate exchanges. There are eight futures exchanges in the United States:

  • CME Group International Monetary Market (IMM)
  • Nasdaq Futures Exchange (NFX)
  • Intercontinental Exchange (ICE)
  • Chicago Board Options Exchange (CBOE / CFE)
  • Chicago Climate Exchange (CCX)
  • Minneapolis Grain Exchange (MGEX)
  • Nadex
  • OneChicago (Single-stock futures (SSF's) and futures on Exchange traded funds (ETFs)

Only futures brokers and commercial traders who pay to be members of an exchange can trade directly on an exchange. But retail traders can trade futures by opening an account with a registered futures broker.

What are margins in futures trading?

To enter a position on a futures contract, you only have to deposit a percentage (aka initial margin) of the contract’s total value into your futures broker account. Initial margins are set by futures exchanges and can range anywhere between 4%-15% of a contract’s total value.

At the close of each trading day, futures exchanges compare the price of a futures contract to the current market price of the underlying asset (aka mark-to-market.) Then futures brokers adjust their traders’ accounts by either adding or subtracting money — depending on whether a trader is winning or losing. Brokers require traders to keep a minimum amount in their account (aka maintenance margin) at all times to cover any daily losses.

If a trader doesn’t have enough in his or her maintenance margin account, a broker should tell him or her to add funds, which is known as placing a margin call. If the trader doesn’t deposit more money in their account, he or she will have to give up their position on the futures contract.

How do you close out a futures contract?

Traders have two options to avoid letting their contracts expire:

  • Close their position by offsetting. Retail traders can close their position on a contract by entering the opposite position on the exact same contract. This is called “offsetting.” Say a trader who is long on gold (buyer position) wants to close their position. The trader can simply enter a short position (seller position) on the same gold contract with the same expiration date to cancel their long position. Traders offset their position on a contract when they want to claim profits or to get out if they’re losing.

  • Extend the contract with a rollover. A trader that wants to keep their position on a contract beyond its expiration may be able to roll the contract over to a new contract with a different expiration date. Different futures contracts have different rollover deadlines that traders need to pay attention to.

How does trading stock index futures work?

A stock index is a measurement of the value of a portfolio of stocks. An index uses a mathematical average to try to reflect how a particular market or segment is performing. The value of a stock index is expressed in points.

When you trade stock index futures, you’re speculating whether the index will go up or down in the future. For example, the S&P 500 is a futures contract that aims to follow the S&P 500 index. It has a multiplier of $250. This means that each index point that the S&P 500 index moves up or down is worth $250.

Say you take a short position as a seller of an S&P 500 futures contract with an agreed-upon future index value of 3040. If the index rises 5 points to 3045 by the end of the trading day, you’ll lose $1,250 (5 index points times $250.) But if the index falls 5 points to 3035, you’ll gain $1,250.

The Chicago Mercantile Exchange (CME Group) offers smaller contracts that follow the S&P 500, Russell 2000, Nasdaq 100, and the Dow Jones indices with smaller multipliers.

For instance, the E-mini S&P 500 futures contract has a $50 multiplier so each index point that the S&P 500 moves up or down is worth $50. (“E” stands for “electronic” and “mini” stands for “miniature.”)

The Micro E-mini S&P 500 has a multiplier of $5. The Micro E-mini Nasdaq-100 has a $2 multiplier, and the Micro E-mini Dow Jones has a $0.50 multiplier. Smaller futures contracts can expose beginning traders to less risk when they’re starting out.

How to get started with trading futures

To start trading futures, you need to open a trading account with a registered futures broker. Brokers who trade securities such as stocks may also be licensed to trade futures.

Some futures brokers offer more educational resources and support than others. Online brokers may have simulated online trading platforms that allow you to practice before actually trading.

Things to compare when researching brokers are:

  • Fees and commissions
  • Types of futures contracts they offer
  • Level of education and help they offer
  • Online trading platform
  • Minimum amount required to open an account
  • Margin requirements

Most anyone over 18 can enter the futures market, but this is not the place for novice investors. Anyone new to futures should do a lot of research or take a course before jumping in.

What are the pros vs. cons of futures trading?

Pros

  • Barriers to entry are low. Micro E-mini stock index contracts have initial margins below $1000.
  • You may be able to make more money with less than with stocks. Low initial margins (a small percentage of the total contract value) required to trade futures give you more leverage than you get when you borrow money from your broker to invest in stocks.
  • There are tax advantages. If you make a profit selling stocks or Forex after owning them for less than one year, you may pay short-term capital gains tax — It’s the same rate as taxes on the rest of your taxable income. Futures profits are taxed under the 60/40 rule: Only 40% of profits are taxed at short-term capital gains rates. The other 60% of profits are taxed at long-term capital gains rates which are 0%, 15%, or 20% depending on your taxable income and filing status.
  • There is no Pattern Day Trader rule for futures contracts. A Pattern Day Trader is a stock or options trader who executes four or more trades from the same margin account within five days. The Financial Industry Regulatory Authority (FINRA) requires Pattern Day Traders who trade stocks or options to maintain at least $25,000 in their brokerage account, or they can’t trade. Pattern Day Trader rules do not apply to futures traders.

Cons

  • You may take on more risk. Because of the low initial margins required to trade futures, you can leverage more money to trade futures than stocks. When you leverage more money, you can lose more money.
  • Futures expose you to unlimited liability. If the market price of an asset continues to move against your favor, you will continue to lose money until you either close your position or your maintenance account is drained. In the event of a violent price swing, you could end up owing your broker.
  • You could lose your investment before you get a chance to win. Futures brokers adjust traders accounts daily. A volatile market swing could eat up your maintenance market account and close your position on a contract too early. You might miss out if the price ends up swinging in your favor later.

*Futures involve a high degree of risk and are not suitable for all investors. You could lose a substantial amount of money in a very short period of time. The amount you may lose is potentially unlimited and can exceed the amount you originally deposit with your broker. This is because trading security futures is highly leveraged, with a relatively small amount of money controlling assets having a much greater value. Investors who are uncomfortable with this level of risk should not trade futures.

*Because of the leverage involved and the nature of futures transactions, you may feel the effects of your losses immediately. Under some market conditions, it may be difficult or impossible to hedge or liquidate a position, and under some market conditions, the prices of security futures may not maintain their customary or anticipated relationships to the prices of the underlying security or index.

Margin trading involves interest charges and risks, including the potential to lose more than any amounts deposited or the need to deposit additional collateral in a falling market. Before using margin, customers must determine whether this type of trading strategy is right for them given their specific investment objectives, experience, risk tolerance, and financial situation. For more information please see Robinhood Financial’s Margin Disclosure Statement, Margin Agreement and FINRA Investor Information. These disclosures contain information on Robinhood Financial’s lending policies, interest charges, and the risks associated with margin accounts. 20200103-1048580-3152881

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