Futures 101

Futures are a big part of global financial markets and demand a comprehensive understanding before jumping in. In this post, I will delve into the basics, going over what they are, the types you can engage in, and where they’re traded.

What are Futures?

Futures are financial contracts, similar to options, that commit two parties to buy or sell an asset at a specific price on a set future date. These contracts are traded on exchanges, kind of like stocks, and cover various assets, including commodities, stock indexes, interest rates, and currencies.

Let’s use an example to get a sense of how they work. Imagine a trader anticipating a rise in crude oil prices. They purchase a crude oil futures contract at $ 75 per barrel. If the price escalates to $ 80 and they sell the contract, they pocket a $ 5 profit per barrel. With one contract typically representing 1,000 barrels, that’s a potential $5,000 gain. However, if the price plunges to $ 70 instead, they could face a $ 5,000 loss. This volatility is what makes futures trading risky.

Many companies utilize futures as a tool to hedge against price fluctuations. An example of this in action is if an airline invests in fuel futures to lock in a stable cost. They could do this because even if fuel prices surge, the airline’s expenses will remain at the agreed price for the future, providing security. The amount will be paid on the specified date, ensuring financial planning and stability.

**Side Note: I want to cover the topic of hedging in finance and investing briefly. Hedging is a strategy used to mitigate risk on an investment, usually by investing in a related asset likely to move in the opposite direction of the primary investment. This is to reduce losses if the primary investment’s return is unfavorable.

Major Categories of Futures

Commodity Futures

These contracts cover physical goods such as energy products, agricultural produce, and precious metals. Crude oil futures are traded on NYMEX energy markets, and metals like gold and silver are traded on COMEX. Agricultural contracts such as wheat, corn, and soybeans trade on CBOT.

Currency Futures

Currency futures are contracts to exchange one currency for another on a future date at a pre-agreed exchange rate. Multinational companies widely use them for hedging and by investors to speculate on currency movements. The CME Group pioneered currency futures in the 1970s and remains a key player.

Currency futures pricing is influenced by the spot exchange rate and the interest rate difference between the two currencies.

Equity Futures

Equity futures include both index futures and single stock futures. Index futures like the S&P 500 E-mini and Nasdaq 100 are widely used for hedging and speculation and are traded on CME.

On the other hand, single stock futures are contracts on individual company shares. These are often traded on Eurex, allowing traders to gain exposure to specific companies without owning the underlying stock.

Interest Rate Futures

These contracts are based on instruments like Treasury bonds and short-term rates like Eurodollars. Institutional investors commonly use them to hedge against or speculate on interest rate changes. Examples include Treasury futures on CME and Euribor futures on Euronext.

Final Note: As always, this is only some information to scratch the surface. There are other types of futures and complex things to know about investing in them, including various strategies to incorporate into your portfolio. If you would like to learn more, please tell me in the suggestion box and leave a comment.

Disclaimer:

This blog post is for educational and informational purposes only. It is not financial advice. I am not a licensed financial advisor, and nothing in this post should be interpreted as a recommendation to buy or sell any financial instrument. Trading involves risk, and results are not guaranteed. Past performance is not indicative of future results. Compensation may be received through affiliate links or program promotions. Always do your own research and consult with a licensed financial professional before making any investment decisions.