Futures are like stocks with an end date
Imagine that you own 100 shares of Apple stock that expire on December 31st. On that date, all your Apple stock disappears from your account, and the stock’s value gets deposited in cash. You might have made money or lost money over that time, depending on how Apple’s share price changed between when you bought it and when you were ‘forced’ to sell it.
That’s pretty much how Futures work. They have some value on the day you buy them and a different value when you sell them, or they expire. If you don’t sell the Futures contract before it expires, then you will be ‘forced’ to sell it. Your account cash balance will depend on the change in value between when you purchased them, and when you sell them, just like buying and selling a stock. Investors rarely hold Futures contracts to expiration.
Futures are not about predicting the future price
Futures get their name from the contract’s nature, which is a contract to execute a purchase and sale in the future. Commodity producers and consumers use Futures to lock in today’s price for a future transaction. For example, a corn farmer can enter a Futures contract in May to sell corn in September.
At any given time, the underlying instrument’s price is the main factor determining a Futures contract price. The Futures price is also affected by factors like storage costs and the expected evolution of supply and demand between that time and when the actual purchase and sale occurs. For physical commodities, storage costs and the evolution of supply and demand are significant factors in Futures pricing. For Financial Futures, like S&P 500 and Treasury Bond Futures, storage costs and expectations of supply and demand play almost no pricing factor.
Futures contract prices move around frequently
Let’s say you own an S&P 500 Futures contract expiring a year from now. If the S&P 500 index goes up 5% today, then your contract’s value goes up 5% today. Similarly, if the S&P 500 index goes down 5% today, then your contract’s value goes down 5% today. It’s that simple. The fact that the contract expires in a year has almost no impact on the value today.
Futures allow you to create leverage without borrowing
Leverage is the main reason for investors to understand and use Futures. Futures are usually the least expensive way to create leverage. Though, all leverage comes with a cost. When you borrow to create leverage, the lender charges you interest. When you use Futures to create leverage, the price is slightly more than the Fed Funds rate. That rate sets the lowest cost for short-term borrowing in the US.
You don’t have to put up the full value of the contract
Contracts create leverage. No cash leaves your account when you ‘buy’ a Futures contract. That’s because you haven’t bought anything; instead, you’ve entered an agreement. You’ve agreed to buy something at the contract’s expiration date. However, as a downpayment on that future transaction, your broker will insist that you keep ten to twenty percent of the contract’s transaction value in cash. You can still invest the remaining eighty to ninety percent of your account in something else. That’s the leverage.
There’s more to learn if you want to trade Futures
I’ve shared some points here to help you have a basic understanding of Futures. This understanding is useful if you invest in a product that uses Futures or swaps, like INDEX+ or leveraged ETFs. However, there are important nuances to understand before you trade Futures. Those nuances include but are not limited to: buying contracts, selling contracts, margin requirements, mark-to-market valuation, cash settlement, delivery constraints, counterparty risk, roll costs, forward curve shape, and more.
Futures are not appropriate for every investor. Futures involve the risk of substantial loss
That’s a required disclaimer. It’s important because it’s true. Always consult a professional about the risks of investing.