What Are Futures and How Do they Work?

Futures are financial contracts that obligate the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.

Futures contracts detail the quantity and quality of the underlying asset and are standardized to facilitate trading on a futures exchange. Some of the most common underlying assets for futures contracts include commodities, stocks, and bonds. Futures can also be used to hedge against risk or speculate on the price movement of the underlying asset.

Futures contracts are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here's an overview of how they work:

• Agreement: The buyer and seller enter into an agreement to buy or sell a specific asset. This agreement specifies the quantity of the asset, the price per unit (the "strike price”), and the date of delivery (expiration date).

• Standardization: The contract is standardized, meaning that it specifies the quality and quantity of the commodity. This standardization is what allows futures contracts to be traded on exchanges.

• Margin and Leverage: To open a futures position, you don't need to pay the full value of the contract up front. Instead, you only need to deposit a fraction of that value, known as the "initial margin." This provides leverage, which can potentially amplify profits but also losses.

• Marking to Market: At the end of each trading day, futures contracts are "marked to market," meaning the change in the value of the contract is settled daily based on the market price. If the market price moves against your position, you may need to deposit additional money into your account to maintain your position, known as a "margin call."

• Settlement: As the delivery date approaches, the futures contract can be settled in one of two ways: physical delivery or cash settlement. In physical delivery, the seller delivers the underlying asset to the buyer. In cash settlement, the parties simply settle the net cash difference. Most futures contracts, particularly financial futures, are settled in cash. 

• Hedging and Speculation: The primary uses of futures contracts are for hedging and speculation. Hedgers use futures to reduce the risk of adverse price movements in an asset, or to protect another position in the portfolio. Speculators, on the other hand, take on risk in the hope of making a profit.

The vast majority of futures contracts are closed out before their expiration date.

To close out a futures contract, the holder does the opposite of what they did to open it. If they bought a contract to open their position, they sell one to close it. If they sold a contract to open their position, they buy one to close it. This process offsets the original position in the market.

Let's say you're a farmer planning to grow 100 bushels of corn, and it's currently winter. You're worried that by the time you harvest your corn in the fall, the price of corn might have dropped. To protect yourself, you enter into a futures contract agreeing to sell your 100 bushels of corn at a specific price when you harvest it.

On the other side of this contract might be a cereal manufacturer who needs corn for their product. They're worried that the price might rise, and that their costs will increase. So the cereal manufacturer enters into a futures contract, agreeing to buy those 100 bushels of corn at the agreed-upon price when it's harvested.

Futures contracts can therefore help manage price risk. However, it's important to remember that futures trading can be complex and may involve significant risk. Therefore, futures aren’t necessarily suitable for all investors and traders. 

Futures contracts can be used for both speculation and hedging in the financial markets. 

Speculation

Speculators aim to profit from price changes in the futures market. They buy futures contracts when they expect the prices of the underlying assets to increase, hoping to sell the contracts later at a higher price. Conversely, they sell futures contracts when they anticipate prices to fall, intending to buy them back later at a lower price.

Looking at an example, assume a trader expects the price of oil to rise over the next six months. That trader might therefore speculate on the price of oil, and purchase a futures contract at the current price, hoping to sell it at a higher price.

If, after six months, the price of oil has risen to $80 per barrel, the trader can sell the contract and make a profit of $10 per barrel (ignoring trading costs and margin requirements).

Keep in mind, this strategy also comes with risk. If the price of oil falls, the trader will suffer a loss.

Hedging

Hedgers often use futures to secure a future price for a product they sell/buy, or to protect against adverse price movements.

Looking at an example, assume a farmer anticipates growing 5,000 bushels of soybeans over the next six months. The farmer is worried that the price of soybeans will drop before the crop is harvested.

To help mitigate risk, the farmer could sell a futures contract for 5,000 bushels of soybeans at the current market price. If the price drops over the next six months, the farmer's loss on selling the soybeans in the market would be offset by the gain on the futures contract.

If the price rises instead, the farmer will get a higher price when selling his crop, but will lose on the futures contract. These transactions will largely offset each other, protecting the farmer from significant price risk.

Futures contracts cover a wide array of assets which can be grouped into several main categories:

• Commodity Futures: These are contracts to buy or sell a specific quantity of a commodity at a predetermined price and date. Commodities are usually raw materials or primary agricultural products. Examples include oil, gold, natural gas, wheat, corn and soybeans.

• Financial Futures: These include futures contracts on financial instruments. They can be divided into several subcategories:

• Stock Index Futures: These are agreements to buy or sell the value of a specific stock index at a specified future date. Examples include S&P 500 futures, Dow Jones Industrial Average futures, and NASDAQ 100 futures.

• Currency Futures: These involve contracts to exchange one currency for another at a specified future date and at a price fixed on the purchase date. They are used by both currency traders looking to speculate on future currency movements and businesses looking to hedge against foreign exchange risk.

• Interest Rate Futures: These are based on an interest-bearing financial instrument, such as a government bond. Traders use them to speculate on the direction of interest rates or to hedge interest rate risk.

• Bond Futures: These are contractual obligations for the contract holder to purchase a bond on a specified date at a predetermined price. They are used by speculators anticipating changes in interest rates and by institutions to hedge against price changes in their existing bond holdings.

• Equity Futures: These are futures contracts on individual stocks. They are not as common as stock index futures due to the risks and regulations associated with them. However, single-stock futures (SSFs) are available on certain platforms.

• Cryptocurrency Futures: With the rise of digital assets, futures contracts on cryptocurrencies like Bitcoin and Ethereum have emerged. They allow traders to speculate on the future prices of cryptocurrencies.

Each of the above categories serves the dual purposes of allowing hedging for risk management and providing opportunities for speculation. As with any investment, futures come with risks, and they should be used judiciously and with a clear understanding of those risks.

In order to learn how to trade futures, investors and traders can follow these general guidelines:

1. Learn about Futures: Start by learning as much as possible about futures trading. Understand what futures are, how they work, the terms used in futures trading, and the risks involved. Read books, take online courses, and follow market news and trends. It's also helpful to learn about the specific commodities or assets you're interested in trading. It may also help to “mock trade” (i.e. paper trade) the futures market before deploying an active position
2. Choose a Broker: Factors to consider when choosing a broker include their reputation, trading platform, customer service, educational resources, and commissions/fees. Trading futures at tastytrade is quick and easy, whether you’re utilizing the active trader interface or the traditional desktop, web, or mobile app platforms
3. Open a Trading Account: After choosing a broker, you'll need to fill out an application to open a trading account. This usually involves providing some personal information and financial details. You may also need to answer questions about your trading experience and objectives, as trading futures is not suitable for everyone due to the risk involved. The tastytrade account opening process is seamless, and can be done on your desktop or mobile tastytrade app
4. Fund you Account: Once your account is open, you'll need to deposit funds to meet the initial margin requirements for the futures contracts you wish to trade. There are a number of different ways you can easily fund an account at tastytrade
5. Develop a Trading Plan: Determine your investment objectives, risk tolerance, and specific criteria for entering and exiting trades. It may also be beneficial to paper trade (i.e., practice trading with simulated trades) to test your trading plan before you risk real money
6. Open your First Trade: Once you have a plan, you can start trading. This involves buying (if you expect the asset's price to increase) or selling (if you expect the asset's price to decrease) futures contracts
7. Monitor your Trades and Adjust Accordingly: Keep an eye on your positions and be ready to adjust if market conditions change. This may involve setting stop-loss orders to limit potential losses, adding to positions if they're doing well, or closing positions to take profits or cut losses. You can create futures alerts on the tastytrade platform that notify you when a product reaches a certain price level, for example
8. Close your Position: Before the futures contract expires, you'll generally want to close your position to avoid taking delivery of the underlying asset (or being required to deliver it). This is done by taking the opposite position on the same contract

Remember that futures trading is complex and can involve substantial risk. It may not be suitable for all market participants. 

As always, you should only risk capital that you can afford to lose. It may also be prudent to seek advice from a financial advisor or a professional with experience in futures trading before entering the market. 

Futures and stocks are both types of financial instruments, but they are very different in many respects. Here are some of the key differences:

Ownership

When you buy stocks, you become an owner (shareholder) of a portion of the company, with rights to a proportion of the company's assets and earnings, as well as voting rights in many cases.

Futures are not ownership instruments. They are contracts that obligate the buyer to purchase, and the seller to sell, a specific asset (like a commodity or financial instrument) at a predetermined future date and price. There is no claim to assets or earnings beyond the specifications of the contract.

Contract Terms

Stocks can be held indefinitely, as long as the company remains publicly traded.

Futures have a finite lifespan; they expire on a specific date in the future. Before this date, the contract will need to be sold, otherwise it will be settled by physical delivery or cash settlement.

Leverage

When buying stocks, the transaction is usually financed with cash, meaning you pay the full price of the shares upfront, although buying on margin is also possible.

Futures contracts, however, require only a small fraction of the contract's value (called margin) to be put down when the contract is entered into. This creates leverage, which can amplify both gains and losses.

Trading Hours

Stock trading hours are typically limited to the business hours of the stock exchange, with some possibility for after-hours trading.

Futures contracts, on the other hand, are often tradable nearly 24 hours a day, depending on the contract and the exchange.

Dividends

Stocks often pay dividends to shareholders, assuming the company is profitable and chooses to distribute some of those profits to its shareholders.

Futures contracts do not pay dividends. The profit or loss from a futures position comes from the change in the underlying asset's price.

Marking to Market

The value of a stock position changes as the market price changes, but profits or losses are not realized until the position is closed. 

Futures contracts, on the other hand, are "marked to market" daily, which means the change in the market value of the contract is settled at the end of each trading day. This could result in a margin call if the market moves against your position and the money in your account is insufficient to cover the loss.

These differences mean that stocks and futures serve different purposes in an investment portfolio and come with different risk and return profiles. It's important for investors to understand these differences and to consider their own financial goals, risk tolerance, and market approach when deciding to trade stocks, futures, or both.