Let’s talk about stock futures. U.S. futures got their start as a trading commodity in the mid-1800s. At the time, farmers were still transporting crops into cities on the hopes of finding a buyer at agreeable prices. But prices fluctuated frequently, and often wildly, based on factors such as the season, type of produce, and current supply and demand in the region.
Eventually, futures cropped up as a way to mitigate some uncertainty in the process. These were fairly simple contracts that stipulated an exchange of goods for a set price at a predetermined date.
But these contracts could also be traded and borrowed. For instance, one restaurant could buy a futures contract for apples from another, or sell their contract in the hopes of repurchasing it later at a lower price.
This beget the thriving derivates market we have today, where futures contracts are bought and sold for all manner of commodities, currencies, stocks, and even market indices.
What are Futures?
Futures are derivative financial contracts that require action from both the buyer and seller at a future date. The buyer will be required to buy an asset at a set date and price, while the seller must sell the asset at a set date and price. (Futures differ from options, which give investors the right but not the obligation to purchase assets.)
Futures contracts detail specifics such as the quantity and price of the underlying asset, as well as the expiration date. Having standardized conditions allows these contracts to be traded on regulated futures exchanges. This contract must be fulfilled regardless of the current market price or conditions upon expiration.
Futures are called derivates because they derive their price from the underlying asset. In ye olden times, these assets were physical commodities such as crops, natural gas, and crude oil. Today, the derivates market has expanded to include assets like:
- Stocks and stock indices, most famously the S&P 500 Index
- Currencies, such as the U.S. dollar, British pound, and euro
- Precious metals like gold and silver
- U.S. Treasury bonds and other products
Futures are also considered a leveraged financial instrument, as an investor or institution only has to lay down a portion of the contract’s cost in order to trade. This relays potential for outsized gains for the investor – as well as tremendous (even unlimited) losses.
As such, futures trading is an advanced instrument best suited for experienced investors and institutions.
What are Stock Futures?
Stock futures are futures contracts that focus specifically on stocks or the stock market. Individual investors use these contracts to profit on price swings, while institutional investors often use them to hedge against risk.
Stock futures often use high leverage, which means that traders don’t front 100% of the contract value when they enter the trade. Instead, the broker will require an initial margin amount, or a fraction of the total contract value. This amount varies based on:
- The broker’s terms and conditions
- Contract size
- The creditworthiness of the investor
Stock futures are popular not just for their outsized return potential, but for the near 24/7 market that allows for moment-by-moment profit-taking. Unlike the stock market, stock futures trading begins at 6pm on Sundays, and remains open until 5pm on Fridays. Trading halts for a 30-60-minute window at the end of each business day.
Single Stock Futures
Single stock futures, or SSFs, are futures contracts where the buyer, who takes the “long” position, promises to pay a specified price for 100 shares of a single stock on the predetermined delivery date. The seller, who takes the “short” position, similarly promises to deliver the stock at that price on the day.
SSF contracts are standardized for trading, similar to commodity and currency futures. They include the following features:
- Contract size: 100 shares of stock
- Margin requirement: usually 20% of the contract’s cash value
- Minimum price fluctuation: 1 cent x 100 shares = $1 fluctuation per contract
- Expiration date: quarterly in March, June, September, or December
- Last trading day: third Friday of the expiration month
Unlike stocks, gains and losses in security futures are credited and debited daily to an investor’s account. The amount is based on the settlement price of the contracts at trading close. If the settlement price falls below the investor’s margin requirements, the broker may require additional funds to cover the deficiency – or sell off the contract if the investor can’t pay up.
SSF contracts call for the seller to deliver the shares on the expiration date for the set price. However, more contracts are closed out before expiration. To do so, the buying investor simply opens an offsetting short position that cancels out the delivery obligation by the seller. This eliminates any further gains or losses for the investor.
Stock Market Futures
Stock market futures, also called equity index futures or simply market futures, are contracts that track a specific benchmark index. Whereas commodity futures may require delivery of the underlying goods at the expiration date, market future contracts often settle for cash or get rolled over.
Market futures are designed for traders to track the direction of the underlying equity index. They also serve as lead indicators – an assessment of where investors believe the market will be in the future.
In other words, when you check the state of S&P futures, you’re seeing how much demand there is for contracts that pay off if the underlying index trades higher or lower in the near future. In turn, this tells you what the market expects to happen next – though, of course, it’s not a guarantee.
Equity index futures are popular with investors because they track the movement of the index itself. They’re also fairly liquid compared to other futures contracts and can be easily traded for long or short positions to bet on future market moves.
The S&P 500 Index is the benchmark gold standard for institutions and traders. However, CME has introduced a compact version of market futures for small-time investors that provide more accessibility, liquidity, and better leverage. These “mini” futures trade at 1/5th the cost of a standard large contract and include the:
- S&P 500 E-mini (prefix SP)
- Dow Jones E-mini (prefix ES)
- Nasdaq 100 E-mini (prefix NQ)
- Russell 2000 E-mini (prefix ER)
What are Futures Used for?
Investors buy futures contracts for two primary purposes: speculation and hedging.
Investors who use futures for speculation are doing just that: speculating on the direction of movement of the underlying asset’s price.
If the price rises above the contract’s price, then the investor rakes in a profit. But if the price dips below the contract price, the investor eats the loss. The difference is settled in cash in the investor’s brokerage account.
Speculators can also take a “short” or “sell” speculative position if they think that the underlying asset will decline. In this case, the investor realizes a gain if the underlying asset price falls below the contract price, and they take a loss if the price rises above the contract price.
Investors also use futures to hedge against price movements of the underlying asset. The goal is to prevent losses from unfavorable price changes, rather than to speculate on how far the asset will rise or fall.
Often times, companies will hedge against products that they use or produce to ensure that they don’t incur sudden losses. However, investors and hedge funds often use futures to hedge against assets in their portfolios, too.
Pros and Cons of Stock Futures
Like other asset classes, futures come with a unique set of pros and cons. Keep in mind that futures are a product often traded by experienced investors and major institutions, as well as consuming corporations – and as such, they’re not typically suitable for beginning investors.
Pros of Stock Futures
- May only require a deposit that totals a fraction of the full contract amount
- Futures contracts make for easy speculation on the price direction of the underlying asset
- Gains are amplified due to leveraged positions
- In the case of SSFs, they provide greater flexibility, leverage, and short taking than the underlying stock
Cons of Stock Futures
- Unlimited risk on leveraged positions that may potentially increase far above the contract price
- Gains and losses post to your account daily, meaning that you may lose your position or have to post more funds in your margin account if market movements decrease the value of your position
- Lack of trading interest may negate stop-loss orders if your broker can’t sell a losing futures contract
- In the case of SSFs, they are less liquid, require more vigilance, and convey no stockholder privileges compared to the underlying stock
Why Do Investors Focus on Futures?
Even if you don’t invest in futures, they can be a valuable source of information. For example, futures provide everyday investors with a gauge of how professional traders and institutional investors perceive the health of:
- A particular stock
- The underlying index
- The stock market at large
- A particular commodity
- Or even the broader economy
Additionally, futures are a means for investors to express their ideas of where the market will (or won’t) move. In other words, investors can use futures to lock in their expectations of future performance – regardless of what actually happens.
And because futures contracts trade overnight during the week, the morning “market futures fair value” report on many early-morning business channels tells everyday investors what market futures contracts should be priced at in the coming hours based on the current cash value of the underlying index.
This can provide investors with data about why stocks moved in after- and pre-markets, where larger players expect the market to move, and which securities, sectors, and industries they think is worth investing in (or avoiding) during the coming hours.