When it comes to investing in the stock market, the choices that traders have are virtually endless. While your safest bet is to choose a company with a strong balance sheet and solid future plan, there are other, more speculative investment options that can deliver larger returns. One way to leverage speculation within the stock market is by using future contracts.
There are several ways to use futures, from speculating about movements in a particular firm’s share price to predicting how the overall market is going to change. However, the most important thing to remember is that although futures offer a much higher return than traditional investments, they also carry a higher degree of risk.
Futures Contracts
A futures contract is essentially an agreement between two parties to buy or sell a particular asset at a specific price on a specific future date. The agreement allows both parties to speculate about the movement of an asset in the future and profit from it.
Futures came about as a way for agriculture businesses to protect themselves against major price swings. Farmers were able to hedge against changes in the price of their crops between the time they were planted and when they could be sold. However, that quickly evolved into a way for traders to bet on whether they believe the price of a commodity will go up or down.
Now, although commodity futures like oil and corn tend to be the most popular, there are futures contracts for a wide variety of assets — including stocks.
Futures or Options
Futures contracts are very similar to those of Options, but with one major difference — futures require buyers and sellers to fulfill their contract agreement on the predetermined date while options give them the right to do so. That means that options buyers are under no obligation to buy a stock while futures buyers have to buy the underlying stock regardless of the price when the contract expires.
Using Futures to Predict the Market
Even if you’re not willing to take on the risk of a futures contract, they can still be a valuable tool for predicting market movements. Futures often give investors an idea of where securities are heading before the market opens. Dow Futures is one of the most closely followed futures because it’s based on the DJIA and trading opens earlier than the overall market, giving investors a good indication of where the market will move come 9:30 a.m. in New York.
How the Futures Market Works
Years ago when futures contracts were used largely by farmers to hedge the price of their crops, the end date was pegged to the delivery of the physical asset underlying that contract. However, the majority of futures contracts are now settled in cash without any physical delivery, meaning that traders can enter into futures contracts for, say, crude oil, without actually owning and storing barrels of the commodity themselves. The same is true with stock futures, which traders typically settle in cash before they expire.
The month that a futures contract expires is designated by a single letter following the asset’s ticker symbol. For example, the ticker NGV8 represents a contract for natural gas (NG) that expires in October (V indicates October) of 2018 (shown in the ticker as “8“).
Risky Business
As mentioned above, futures contracts are riskier than buying and selling single stocks, but they have a much higher potential for return. That’s because unlike buyers of a single stock, investors entering into a futures position can essentially wager more money than they have at the time.
For example, someone buying a single stock for $50 has the potential to lose $50 and nothing more. On the other hand, buying a futures contract for the same stock could result in much higher losses because of the leverage involved.
The leverage for the futures contract you’re buying depends on the asset itself, but even tiny price fluctuations can result in massive gains or losses. For example, if you buy a futures contract with 10:1 leverage it means that for $1,000 you can enter into $10,000 position. So, although futures are a popular investment option because they magnify gains, it’s important to remember that they also magnify losses as well.
Are Futures Right For You?
If you’re considering investing in futures there are a few things to consider. The first is timing: how confident are you in your market predictions? Obviously the longer the contract, the more time for your expectations to materialize, but that extra time also comes at a cost.
Buying futures outright without any backup plan also leaves you extremely vulnerable to market swings so it’s worth spending some time examining your chosen futures market and considering defensive positions that will minimize losses. One such protection is a stop-loss order, which tells your broker to sell when the asset gets to a certain price.
As of this writing, Laura Hoy did not hold a position in any of the aforementioned securities.
