If you follow a financial news outlet like Bloomberg, you’ll have certainly seen the green and red flashing boxes in the corner of your screen indicating the performance of various futures prices, or heard Tom Keene report something along the lines of “Nasdaq futures are off 1.3 per cent today.” But what does all this mean? In this short article, I’ll be taking you through some of the basic functions of futures contracts (often just referred to as futures), along with some of the advantages and risks accompanied with investing in them.
Breaking Down Futures
Prices of financial instruments and commodities fluctuate daily, but futures contracts allow businesses and investors to predetermine the price of an underlying asset or commodity at a specified future date. This price you pay is called the ‘future price.’ This will be higher than the spot price (current price on the market) for a range of reasons, including inflation projections and a cost for actually holding the asset, but what’s important is that the price and quantity of the commodity/ underlying asset is set in stone. Irrespective of how the price changes, upon the expiration of the contract, the parties involved are obliged to fulfil the terms of the contract - the buyer will buy, and the seller will sell, at the initially agreed price.
Futures markets are open virtually 24 hours per day, 6 days a week, but naturally, each type of futures contract has specific trading hours. Nevertheless, the opportunities to trade futures spans across commodities, such as gold, index funds, bonds and even currencies and crypto currencies. The possibilities are endless.
Why Use Futures?
Using futures is extremely useful for many businesses. It allows them to manage risk by potentially avoiding paying more money for a commodity at a later date. To make things a bit easier, here is a real-life example.
Let’s say that a coffee shop has established its expenses and they know that they spend £0.50 on coffee beans per cup of coffee they sell. If the price of coffee beans increases, it means their margins will suffer. So, this coffee shop can enter a contractual agreement to buy a certain amount of beans at a forward price. Should the price of coffee beans skyrocket for whatever reason, it doesn’t matter; the owner knows the amount they are getting, the price they are paying, and when. These contracts simply allow businesses to exert more control over their expenses, and reduce the chance of struggling in the future should prices of essential commodities become too high.
Futures also provide a great opportunity to independent investors who naturally speculate on what price a product will trade at in the future. Gold futures, for example, are usually a popular purchase for those who are forecasting economic downturns. Some investors see gold as a safe haven during difficult times, which can increase its value and thus benefit those who hold gold futures. Similarly, with the ever-evolving situation in the Middle East, many see buying oil futures as sensible to either have a guaranteed price for oil, or to take advantage of the price volatility and secure a strong ROI (return on investment).
To see how investors make money from trading futures, we’ll use another real-life example to simplify things. Let’s say an investor thinks the price of silver is going to increase over the next year, they might decide to take a long position and pay a forward price for this commodity. Assuming they want 50 ounces and the forward price for one ounce is £300, they will be buying 50 ounces of silver for £15,000 (£300 x 50 ounces). A year on, the spot price of silver is now £400 per ounce, but because the investor used a futures contract, this increase in price only benefits them. Now, the investor can sell their 50 ounces of silver on the stock market at £400 per ounce [£400 x 50 = £20,000], netting them a return of £5,000.
It is also worth mentioning that futures do offer some flexibility when it comes to risk, as you can exit the trade when you want. If an investor has taken a long position on a futures contract and wants to take their profit without having to wait until the expiration date, they could complete a sell trade of the same commodity, amount, and expiration date. This offsets the original contract and the price difference between the two contracts would be the amount the investor would receive in profit.
Futures allow businesses to follow a ‘hedging strategy.’* This can help them to avoid the devastating impacts of the price increase of a certain product.
In general, futures contracts can help stabilise prices of consumer goods. For example, the fact that those who sell wheat, and those using the wheat to make cereal can use these futures, means that when you next go into your local supermarket, Weetabix won’t cost the same amount as an iPhone.
Investors don’t have to put up all of the capital when trading futures; most contracts use leverage. This means by putting down a small amount of the money, you can control a large amount of assets for a fraction of the price. Furthermore, should your speculations be correct, you could be set to make a strong profit when the contract expires.
* A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. (Investopedia)
Being obliged to carry out the terms of the contract is a great risk. It may be that at the expiration date of the contract, the spot price is in fact lower than what you are paying for, essentially meaning you are overpaying.
This risk of overpaying is heightened by using leverage. While leverage can bring you impressive returns, if the price does the opposite of what you are expecting, then the losses will be even further amplified.
Hopefully, this article has given you a brief insight into how futures work and why businesses and investors rely on them heavily to manage risk, but also gain some strong returns. Naturally, this is just an overview of the futures market, and there is a lot more to learn, so make sure to do your research before jumping into anything! We will be covering futures in more detail in a future (if you pardon the pun) article!
If you enjoyed this Investing 101 piece, be sure to check out our other articles in this series on our blog and let us know in the comments what you think about the futures market.