A futures contract is an agreement to buy or sell an asset at a future date at an agreed-upon price. All those funny goods you’ve seen people trade in the movies — orange juice, oil, pork bellies! — they’re futures contracts.
Futures contracts are standardized agreements that typically trade on an exchange. One party to the contract agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The other party agrees to provide it.
The futures market can be used by many kinds of financial players, including investors and speculators as well as companies that actually want to take physical delivery of the commodity or supply it.
How futures contracts work
An airline company may want to lock in jet fuel prices to avoid an unexpected increase. So it buys a futures contract agreeing to buy 1 million gallons of fuel, taking delivery 90 days in the future, at a price of $3 per gallon.
Someone else, a fuel distributor perhaps, wants to ensure that it has a steady market for fuel. It wants to protect against an unexpected decline in fuel prices, so it will enter into a futures contract. It agrees to sell that 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.
In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it’s the basis of their business. They turn to the futures market to manage their exposure to the risk of a price swing.
There are also people who seek to make money off of price changes in the contract itself, trading it merely to buy or sell it on to others. These are investors or speculators. If the price of fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell that contract for more to someone else. These types of traders usually have no intention of taking delivery of the underlying commodity; they’re just in the market to wager on price movements.
With speculators, investors, hedgers and others buying and selling daily, there is a lively and relatively liquid market for these contracts.
» Get started: These are our top brokers for futures trading
It’s more than commodities: Shares, stocks (and bitcoin) too
Commodities represent a big part of the futures-trading world, but it’s not all about hogs, corn and soybeans. You can also trade futures shares of ETFs and even individual stocks and bonds as well. And one of the biggest splashes was made recently when bitcoin debuted on the futures exchanges. Some traders like these vehicles because of the greater potential for leverage than just owning the securities directly. A trader can take a substantial position while putting up a relatively small amount of cash.
One common application: Someone who wants to hedge exposure to the U.S. stock market may short-sell a futures contract on the Standard & Poor’s 500. If stocks fall, he makes money on the short, balancing out his exposure to the index. Conversely, the same investor may feel confident in the future, and seek to buy a long contract – gaining a lot of upside if stocks move higher.
What’s in a futures contract?
Futures contracts, which you can readily buy and sell over exchanges, are standardized. Each futures contract will typically specify all the different contract parameters:
- The unit of measurement.
- How the trade will be settled – either with physical delivery of a given quantity of goods, or with a cash settlement.
- The quantity of goods to be delivered or covered under the contract.
- The currency unit in which the contract is denominated
- The currency in which the futures contract is quoted.
- Grade or quality considerations, when appropriate. For example, this could be a certain octane of gasoline or a certain purity of metal.
If you are getting involved in trading futures, you have to be careful, because you don’t want to have to take physical delivery. Most casual traders do not want to find themselves obligated to sign for receipt of a trainload of swine when the contract expires and then figure out what to do with it.
The risks — margin and leverage
Many speculators borrow a substantial amount of money to play the futures market. It’s the main way to magnify commodities’ relatively small price movements to a point where they potentially create profits that are worth the time and effort. But borrowing money also increases risk: If markets move against you, and do so more dramatically than you expect, you could lose more than you invested.
Leverage and margin rules are a lot more liberal in the futures and commodities world than they are for the securities trading world. A commodities broker may allow you to leverage 10:1 or even 20:1, depending on the contract, much higher than you could obtain in the stock world. The exchange, typically the Chicago Board of Exchange (CBOE), sets the rules.
The greater the leverage, the greater the gains, but the greater the potential loss, as well: A 5 percent change in prices can cause an investor leveraged 10:1 to gain or lose 50 percent of her investment. This volatility means that speculators in the futures markets should have the discipline not to overexpose themselves to any given risk.
Getting started trading futures
If you believe the futures markets are right for you, it’s not difficult to get started. Open an account with a broker that supports the markets you want to trade. The futures broker will likely ask how much experience you have with investing and what your income and net worth are. These questions are designed to determine the amount of risk the broker will allow you to take on, in terms of margin and positions.
There is no industry standard for commission and fee structures in futures trading. Every broker provides varying services. Some provide a good deal of research and advice, while others simply give you a quote and a chart. (To help you get started, NerdWallet has reviewed some of the best futures brokers.)
Some sites will allow you to open up a virtual account. You can practice trading with “paper money” before you commit real dollars to your first trade. This is an invaluable way to check your understanding of the futures markets and how the markets, leverage and commissions interact with your portfolio. If you’re just getting started, we highly recommend spending some time trading in a virtual account until you’re sure you have the hang of it.
Even experienced investors will often use a virtual trading account to test a new strategy. Depending on the broker, they may allow you access to their full range of analytic services in the virtual account.
This post was first published in October 2012 and has since been updated.