• Shahn Khan

What Are Futures & How Do Futures Work?

A futures financial contracts or an agreement to buy or sell something at a future date, for an agreed-upon price. That “something” can be a commodity, a currency, a bond or a stock.

Futures obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Futures are one of the most liquid in nature and most traded futures products

The wins and losses on the futures market fluctuate from day to day depending on the price of the commodity (or bond or stock or currency) that is the basis of the futures contract. If you’re party to a futures contract, your account will be debited or credited according to each day’s price change. A reminder: futures trading creates winners and losers. One person goes long (profits if the price rises) and one person goes short (profits if the price falls). Whoever speculated correctly about how the price would move is the winner. It’s a zero-sum game.

Commodity futures such as in crude oil, natural gas, corn, and wheat

Stock index futures such as the S&P 500 Index

Currency futures including those for the euro and the British pound

Precious metal futures for gold and silver

Real-World Example of Futures:

Let's say a trader wants to speculate on the price of crude oil by entering into a futures contract in May with the expectation that the price will be higher by years-end. The December crude oil futures contract is trading at $50 and the trader locks in the contract.

Since oil is traded in increments of 1,000 barrels, the investor now has a position worth $50,000 of crude oil (1,000 x $50 = $50,000).3 However, the trader will only need to pay a fraction of that amount upfront—the initial margin that they deposit with the broker.

From May to December, the price of oil fluctuates as does the value of the futures contract. If oil's price gets too volatile, the broker may ask for additional funds to be deposited into the margin account—a maintenance margin.

In December, the end date of the contract is approaching, which is on the third Friday of the month. The price of crude oil has risen to $65, and the trader sells the original contract to exit the position. The net difference is cash-settled, and they earn $15,000, less any fees and commissions from the broker ($65 - $50 = $15 x 1000 = $15,000).

However, if the price oil had fallen to $40 instead, the investor would have lost $10,000 ($40 - $50 = negative $10 x 1000 = negative $10,000.

Futures margin can be a double-edged sword meaning it's a pure zero-sum game. Gains are amplified but so too are losses.

As always, it’s important to do your research before investing your hard-earned dollars.

Remember that you can always turn to us for truly professional help.

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