Futures contracts are agreements to buy or sell an underlying asset at a predetermined price on a set future date. Traders and investors like yourself may get into futures trading in search of diversifying their portfolios, risk management or to seek profit.
Futures contracts are agreements made publicly to buy or sell a specific underlying asset at a set future date. An underlying asset can be, for example, a security — Apple Inc. stock (AAPL) is a stock that can theoretically be bought or sold in the future. However, not all stocks have futures contracts. If you want to use stocks as futures contracts, check exchanges like the Chicago Mercantile Exchange (CME) Group to find available Single Stock Futures (SSF).
What sets futures contracts apart is that once the price is agreed upon, it remains fixed until the set date when you buy or sell the futures contract. The Commodity Futures Trading Commission (CFTC) regulates and oversees futures contracts. By setting and enforcing rules, the CFTC ensures fair, transparent and free-from-fraud futures trading.
Future contracts are agreed-upon contracts that are delivered on the due date. This agreement means you must buy or sell in the future with one of the two goals in mind: risk aversion or profit.
Risk management plays a vital role in futures trading, as market fluctuations can lead to significant gains or losses. Stop-loss orders, a widely used tool among traders, are employed by 88% of traders to protect capital and limit downside risk. Similarly, position sizing is an essential component of portfolio protection, with 62% of traders incorporating it into their strategy.(1) By strategically managing trade sizes and setting exit points, traders can better navigate the volatility inherent in futures markets.
To calculate your risk or potential profits, we will provide you with an example, as well as a short explanation of the behavior of each of the three types of futures traders (Speculators, Producers and Position holders).
To calculate your profits or losses on a futures contract, you need to remember some key stakeholders that we will apply to this theoretical example:
Let’s say you buy 1 Gold Futures contract at $1,800 per ounce. The contract size is 100 ounces.
Profit Calculation:
Your profit from this trade is $1,000
| Trader Type | Behavior | Action | Goal |
|---|---|---|---|
| Producers | Use futures to hedge against price risk, ensuring stable revenue. | Sell gold futures at $1,800 to lock in a future selling price. | Protect against falling prices, securing known revenue. |
| Speculators | Use futures to profit from price movements based on market predictions. | Buy gold futures at $1,800 and sell if the price rises to $1,810. | Profit from price fluctuations by predicting market direction. |
| Position holders | Hold futures contracts long-term, regardless of short-term market movements. | Buy gold futures at $1,800 and hold for extended periods. | Maintain positions through market fluctuations for larger gains. |
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Now that you understand what futures contracts are and how they work, we can move on to the typology:
Most investors trade with the four aforementioned types of futures. However, the reason for that is mostly popularity. The second reason people might pick commodities, for example, is because of how easy it is to get into it once you’re already a savvy investor. Nevertheless, here are additional types of futures contracts to consider:
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The main difference between futures contracts and forward contracts is that futures are traded on the exchanges, while forwards are traded directly between two parties over the counter (OTC). Even though they are both based on underlying assets, contractual obligation and a predetermined price on a specified future date, the similarities end there.
Futures are highly standardized contracts traded on exchanges where they are regulated and overseen by government authorities for either speculation or hedging against price fluctuations. On the other hand, forward contracts are customized agreements traded over the counter directly with much less regulation, as they are private agreements with the main goal of hedging specific and less liquid assets.
| Feature | Futures Contracts | Forward Contracts |
|---|---|---|
| Standardization | Highly standardized, with fixed contract terms (size, delivery date, etc.) | Customized to the specific needs of the buyer and seller |
| Trading Venue | Traded on exchanges (e.g., CME, ICE) | Traded over-the-counter (OTC) between two parties |
| Settlement | Can be settled daily (mark-to-market) | Settled at maturity (no daily mark-to-market) |
| Regulation | Regulated by government authorities (e.g., CFTC in the US) | Less regulated, as they are private agreements between parties |
| Liquidity | Generally more liquid due to standardized contracts and exchange trading | Less liquid due to custom terms and private agreements |
| Credit Risk | Lower credit risk due to clearinghouses acting as intermediaries | Higher credit risk since it’s a direct agreement between parties |
| Purpose | Speculation or hedging price risk in liquid markets | Hedging, often for specific and less liquid assets |
The biggest advantage of futures contracts for me is the ability to manage risk and profit from market movements. Those two are not the only ones, of course, but they are the ones most savvy investors are fond of.
Futures contracts have their pros, but they also have some disadvantages, like all the other investment options:
Futures contracts allow traders and investors to lock in a price for an asset to be delivered later. These contracts are used to manage risk or to profit from price changes. Traders can use futures to hedge against price fluctuations or speculate on the movement of commodities, currencies or other assets.
To start trading futures, it’s essential to choose the best brokerage accounts. A good broker should offer access to the futures markets you want to trade, charge reasonable fees and provide reliable support. Look for a platform that fits your needs and provides the tools to help you succeed.
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