Here at OverTraders.com, we realize that financing and investing can be intimidating, particularly for new, emerging investors. That’s why we’re committed to delivering straightforward, digestible, actionable content to help you feel confident and in control every step of your trading journey. This short article will explain what stock futures are and what they do. It will focus on what they are, how they function, and why they’re key to forecasting market shifts. Whether you want to hedge your portfolio against risk or generate alpha through informed investments, knowledge of stock futures is an indispensable tool in your arsenal.

Understanding Futures

What Are Futures?

Futures are financial contracts obligating the buyer to purchase an asset (and the seller to sell an asset) at a predetermined future date and price. Consider it a contract to purchase (or sell) some commodity down the road at a set price determined today. These contracts are very standardized and traded on a publicly-available exchange, opening the market up to a huge variety of investors. The underlying asset can be anything from commodities such as gold and oil, to financial instruments including stocks and currencies.

Futures contracts are a bedrock of our financial markets. They are used for price discovery, risk management, and speculation. This allows participants to bet against one another on the future course of asset prices. This, in turn, allows them to hedge against negative movements as well. Futures allow a farmer to lock in a price for their crop before they are sold. This tactic insulates them from any possible price decreases prior to harvest time. A food producer may benefit from futures contracts if they want to hedge against increased future raw material costs. This strategy protects them from future price increases.

The value of a futures contract indicates the future price at which the market expects to be able to buy or sell the underlying asset. Many factors play into this price—from the basic supply and demand dynamic, to changes in other economic indicators, to geopolitical events, to overall investor sentiment. By looking at the futures price themselves, investors can understand what the market expects and where prices may be headed in the future.

What Is Futures Trading? A Simple Explanation

Futures trading is simply the process of buying and selling these futures contracts on an exchange. When you purchase a share of stock, you are purchasing a fractional ownership in the company. By buying a futures contract you are committing to buy (or sell) the underlying asset at a future date. Investors use futures primarily for 3 reasons. They mostly hedge existing positions, speculate on future price movements, and exploit price differences between different markets.

Futures market, which is very highly leveraged. This allows investors to potentially have control over much larger positions with only a fraction of the capital. That can increase potential gains and it increases potential losses too. This leverage makes futures trading a high-risk, high-reward activity, requiring a thorough understanding of market dynamics and risk management techniques.

Futures contracts have rigorous requirements attached. They specify the amount and quality of the underlying commodity, delivery date, and settlement method. This added standardization makes it much easier for traders to trade and provides transparency back to the market. Exchanges play a vital role as intermediaries, ensuring the fulfillment of trades for both buyers and sellers, lowering the counterparty risk of default.

The Two Sides of Futures Trading: Producers vs. Traders

Futures trading is essentially a game between two main players: producers (or hedgers) and traders (or speculators). Producers use futures to hedge against risk of price changes. For example, a wheat farmer might sell wheat futures to lock in a price for their harvest, regardless of what happens in the market later. They cringe at the thought of losing their contract over a reduction in their wheat price impacting their bills’ bottom line. At the same time, they’re deep in preparation for next season. Farmers, traders, and other hedgers rely on futures to protect themselves from catastrophic shifts that are inevitable in both nature and the market. Futures allow their participants—like utilities—to smooth out energy expenses, something which can help protect households from volatile heating costs. On the other hand, producers and merchants who adopt futures have a greater capacity to hedge against risk and personally achieve their own revenue baseline.

For traders, that’s all it is—the rush of short-term profit. Their goal is to identify market trends and forecast price movement directions in order to purchase or sell futures contracts to profit from anticipated price moves. They don't intend to take delivery of the physical goods, if any are involved in the first place, and they're looking to make a profit from the price movement of the underlying asset.

Fundamentals of Futures Trading

Futures Basics

In essence, a futures contract is just a promise. It gives you the right, but not the obligation, to purchase or short a particular asset at a set price on a known future date. Since then, this date has come to be known as the expiration date. When you issue the contract, the price is determined by the contract. This purchase value is the market consensus on what the asset will be worth in the future.

Here's a breakdown of the key components:

Underlying Asset: The commodity or financial instrument being traded (e.g., crude oil, gold, stocks).

Contract Size: The quantity of the underlying asset covered by one contract (e.g., 1,000 barrels of crude oil).

Expiration Date: The date on which the contract must be settled.

Settlement Method: How the contract is settled, either through physical delivery of the asset or cash settlement.

Margin: The amount of money required to open and maintain a futures position.

Forward Contracts and Examples

Forward contracts are similar to futures contracts in that they are agreements to buy or sell an asset at a future date and price. Unlike exchange traded instruments, forward contracts are privately negotiated agreements between two parties and thus not traded on exchanges. This makes it more customizable, but it opens them up to counterparty risk. This last risk is triggered whenever one side fails to uphold their end of the deal.

Here are some examples of forward contracts:

Currency Forward: A company agrees to buy a certain amount of foreign currency at a specific exchange rate on a future date to hedge against currency fluctuations.

Interest Rate Forward: Two parties agree to exchange interest payments on a notional principal amount on a future date to manage interest rate risk.

Commodity Forward: A manufacturer agrees to buy a certain amount of raw materials from a supplier at a fixed price on a future date to secure their supply and protect against price increases.

Futures Contracts and Examples

Unlike forwards, which have no standardization and are done over-the-counter, futures contracts are completely standardized and traded on exchanges. This greater standardization makes them more liquid and transparent than forward contracts. Since the exchange serves as the guarantor, counterparty risk is drastically lowered. Futures contracts are standardized and exchange-listed just like individual stocks are. Participants trade these contracts back and forth all day with each one specifying the asset, volume, delivery date, and settlement process for the underlying asset.

Here are some examples of futures contracts:

Crude Oil Futures: Investors can trade futures contracts based on the price of crude oil, allowing them to speculate on future oil prices or hedge against price volatility.

Gold Futures: Gold futures contracts are a popular way to invest in gold, offering investors exposure to the precious metal without having to physically store it.

These contracts allow investors to trade on the overall performance of a stock market index, such as the S&P 500 or the NASDAQ 100.

Treasury Note Futures: Futures contracts can be used to hedge against fluctuations in prices, such as the use of T-note futures to hedge against fluctuations in 10-year Treasury note yields.

Who Participates in Futures Trading?

Hedgers

Hedgers use futures to reduce the risk of adverse price movements in the underlying asset. Their primary focusing purpose is not on increasing profit, but rather on risk management related to their enterprises or investment portfolio. They have to consciously look for opportunities to hedge everything they do today going forward so that they know they can guarantee enough money for their future outlays. For instance, an airline can hedge against future increases in fuel costs by buying jet fuel futures. This simple strategy protects their bottom line, no matter how high fuel prices go. Speculators seek profit, while hedgers prioritize managing risk. They’re just trying to defend their business model or investment portfolio against the coming storm. Hedgers want a way to guarantee a price today so that they are confident in having sufficient revenue.

Speculators

Speculators seek to make money by betting on the futures market’s price fluctuations. They analyze market trends and try to predict the future direction of prices, buying or selling contracts accordingly. Speculators have no plan or desire to take delivery of the physical commodity, assuming a physical commodity is even part of the chain.

Types of Futures Traders

Here's a broader look at the different types of participants in the futures market:

  • Commercial Hedgers: Businesses that use futures to manage price risk related to their operations (e.g., farmers, manufacturers, energy companies).

Institutional Investors: Large investment firms that use futures for hedging, speculation, and portfolio diversification (e.g., pension funds, mutual funds, insurance companies).

Individual Traders: Retail investors who trade futures for speculation or hedging purposes.

Proprietary Trading Firms: Firms that trade futures for their own account, seeking to profit from short-term price movements.

Common Participants in the Futures Market

Hedge Funds

Hedge funds play a very active role in futures trading, utilizing highly complex strategies to create their returns. They can use futures to hedge other existing positions, speculate on future price movements, or arbitrage between futures and spot markets.

Individual Traders

Now, individual traders can access the futures market through brokerage accounts. There are many reasons why they want to trade futures, from speculation and hedging to portfolio diversification. Individuals can enter the commodities futures market through a managed futures account, available through specialized brokerage firms called Commodity Trading Advisors. The Financial Industry Regulatory Authority requires back account holders to have some minimum balance. This balance cannot be less than 25% of the value of the entire trade.

Institutional Investors

Pension funds and insurance companies are examples of institutional investors who rely on futures to control risk and increase returns. They can use futures to hedge against inflation, interest rate changes, or currency fluctuations.

Market Makers

Market makers are absolutely critical in futures market liquidity. They post bid and ask prices for their futures contracts guaranteeing that there is always a buyer and seller.

Proprietary Trading Firms

First, proprietary trading firms only trade futures on their own account, taking the other side of a trade to make money betting on quick changes in price. This is frequently done with the use of sophisticated trading algorithms and high-frequency trading strategies.

What Can Be Traded in the Futures Market?

Commodities Futures

Commodities futures are contracts to buy or sell raw materials. These are primarily agricultural products including corn, soybeans and wheat, energy products including crude oil and natural gas, and metals like gold, silver and copper. For this reason, farmers and future traders rely on futures as insurance against truly devastating shifts in nature and the market.

Cryptocurrency Futures

Cryptocurrency futures, introduced by many exchanges, give investors the option to speculate on whether the price of cryptocurrencies—like Bitcoin and Ethereum—will rise or fall. These contracts provide an alternative means of exposure to the growing crypto currency market without the need or desire to hold the underlying digital assets directly.

Forex Futures

Forex futures are legally binding agreements to exchange one currency for another at a specific price on a specified future date. They served as a tool for investors to hedge against currency fluctuations or to speculate on future exchange rate movements.

Stock Market Index Futures

Stock market index futures are futures contracts whose value is based on a stock market index. This includes heavily traded indices such as the S&P 500 and the NASDAQ 100. They’re an easy way for investors to make bets on whether the stock market is doing well without needing to purchase different stocks.

Energy Prices, Currencies, and Interest Rates

Futures contracts aren’t only limited to the types I circumvented above. You can find them published on a wide range of assets including energy prices (heating oil and gasoline), currencies (EUR/USD and GBP/USD), and interest rates (Treasury bonds and Eurodollars). Futures trading offers extraordinary flexibility for traders wanting to trade in virtually any market. Using 10 times leverage, a 5% move in the market translates into a jaw-dropping 50% return or loss on your investment.

Key Characteristics of Futures Contracts

Standardized Contracts

With futures contracts comes a high level of standardization. This means the exchange determines the size of the contract, quality of the underlying asset, date of delivery and procedure of its settlement beforehand. This kind of market uniformity makes the buying and selling of credits easier and ensures transparency throughout the process.

Leverage

Futures trading typically employs a great deal of leverage. This enables investors to lever up a sizable position with a relatively small amount of capital. Though this can increase potential returns, it increases the possibility for losses. When you go long, you’re agreeing to purchase an asset at a predetermined price on a later date. Conversely, when you “short,” you essentially enter an agreement to sell an asset at a set price for a future date.

Expiration Dates

Futures contracts have expiration dates, or delivery dates, which is the date the contract must be settled by. Prior to the expiration date, investors can either reapply or let their funds expire. They can do this by either closing their position through an offsetting trade, or rolling it over to a later-dated contract.

Settlement Types

Futures contracts can be settled in two ways: physical delivery or cash settlement. Physical delivery means that the underlying asset actually moves from the seller to the buyer. Cash settlement creates scenarios where one party pays cash to another party. This payment is settled based on the contract price minus the market price of the underlying asset at expiration.

Advantages and Risks of Trading Futures

Advantages 🤑

Leverage: Futures offer high leverage, allowing investors to control large positions with relatively small amounts of capital.

Liquidity: Futures markets are generally very liquid, making it easy to enter and exit positions.

Transparency: Futures contracts are traded on exchanges, providing transparency and price discovery.

Futures can be used to hedge against price fluctuations in the underlying asset.

Risks ⚠️

  • Leverage: While leverage can amplify potential profits, it can magnify potential losses.

Volatility: Futures markets can be very volatile, leading to rapid price swings.

  • Complexity: Futures trading requires a thorough understanding of market dynamics and risk management techniques.

If the market moves against your position, you may receive a margin call, requiring you to deposit additional funds into your account.

Tips for Successful Futures Trading

  • Educate Yourself: Before trading futures, take the time to learn about market dynamics, risk management, and trading strategies.

  • Develop a Trading Plan: Create a detailed trading plan that outlines your goals, risk tolerance, and trading strategies.

  • Manage Your Risk: Use stop-loss orders to limit potential losses and avoid over-leveraging your account.

  • Stay Informed: Keep up-to-date on market news and economic events that could impact futures prices.

  • Practice with a Demo Account: Before trading with real money, practice your strategies with a demo account to get a feel for the market.

Understanding Futures Expiration Dates

Traditional vs. Perpetual Futures

Traditional futures contracts have somewhat arbitrary, fixed expiration dates that we outlined in depth above. Perpetual futures, by contrast, have no expiration date. Their secret sauce is a unique funding mechanism. This strategy allows us to maintain the contract price close to the spot price of the underlying asset.

What Happens at Expiration?

When a traditional futures contract expires there is either a physical delivery of the commodity included in the futures contract or an equivalent cash settlement. If the contract is closed through physical delivery, the short position (the seller) is obliged to deliver the underlying asset to the long position (the buyer). If the contract is settled through cash settlement, the difference between the contract price and the market price of the underlying asset is paid from one party to the other.

Conclusion: Is Futures Trading Right for You?

With the opportunities come risks, and futures trading is not for everyone. When treated as a potential speculative or hedging tool, or a portfolio diversifier, it can become a powerful tool. That’s only possible with an in-depth knowledge of market forces, variables affecting risk, and a well-honed trading strategy. As with any form of trading, you need to determine your level of risk, available capital, and objectives before participating in futures trading. If you’re just beginning to trade futures, practice first in a demo account. As your experience grows, increase your position size slowly over time. The Futures Industry Association just announced record growth in futures trading around the world. It absolutely exploded from 12.1 billion contracts in 2013 to 29.2 billion last year in 2023.

How to Claim Crypto Bonuses with Bybit

(Tangent—in combination with the flatness of preemption and impacts on policy entrepreneurs, this is the reason preemption deserves its own post written by someone focused on it. Don’t worry, we won’t make it too long—)

Bybit is one of the most used crypto exchanges and usually provides new users and current users with Bybit bonuses. To earn these bonuses, you often must jump through a number of hoops. These actions could be anything from funding an account with a deposit, to executing a trade, to referring a friend. Visit Bybit’s website or promotional emails for the most up-to-date instructions on claiming Bybit’s current bonuses.

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Volume Analysis in Trading Strategies

Volume analysis is the practice of looking at the volume behind trading activity to determine the probability of potential price movements. High volume indicates heavy buying or selling activity. Plummeting high volume is a bearish indicator, as high volume indicates strong conviction in the market.

About the Author

Mind Math Money

Mind Math Money is a financial expert and content creator dedicated to providing practical advice and insights on investing, trading, and personal finance. Mind Math Money inspires anyone to gain control of their finances and find freedom. It imparts powerful lessons and unexpected wisdom to equip readers with the tools they need to survive and thrive in the financial jungle.