When using the term stock market futures, typically market participants are referring to stock indices futures. A futures contract, regardless of the underlying asset, is an agreement between parties to exchange an asset at a specific price and date set in the future.
What Are Stock Futures?
Stock market futures are contracts requiring the buyer to buy a stock indices and a seller to sell that same stock indices at a particular price before or on a particular date. The buyer of the futures contract must buy (and the seller must sell) the specified asset at the price in the contract, regardless of the current market price at the time the contract expires.
Futures can exist on:
- Indices
- Commodities
- Bonds
- Individual stocks
- Other assets
Futures vs. Options
Futures differ from trading options because the buyer and seller are contractually obligated to complete the specified transaction. With options, the owner of the option has the right to exercise their option, but is not required to. Sellers of option contracts are required to satisfy the other end of the contract if it is exercised against them.
However, completion doesn't necessarily mean the purchase or sale of shares. Most futures contracts are settled with a cash payment that amounts to the difference between the price on the date the contract was struck and the price on the date it is completed, with no delivery taking place.
How Do Stock Futures Work?
Stock Market Futures allow investors to set a particular price at which to buy or sell stock indices in the future. The most commonly traded stock futures are on the S&P 500 and Nasdaq 100 indices. The entering into a stock indices futures contract protects both the buyer and seller against adverse pricing movements after the date the agreement was entered into.
Two parties set a contract to buy or sell a certain amount of the underlying asset for a set price on a particular date in the future. The contract is to be completed before the expiration date, but each party may close out the contract prior to the expiry date. For instance, a buyer of a stock indices futures contract expiring in September could sell it to another party in July.
How Are Stock Futures Calculated?
The value of the contract depends on the value of the underlying asset. To calculate futures, you multiply the stock price by the number of units in the contract.
Futures = stock price multiplied by the number of units in the contract
To trade futures, investors must pay in margin, usually 10% of the value of the contract, although it can be as high as 20%. The margin serves as collateral in case the market moves in the opposite direction of the position.
Traders who sell a futures contract earn profit if the futures price drops before the expiration date. The buyer of that futures contract will still have to pay the price stipulated in the contract to settle it. If the futures price has dropped in value, the buyer will essentially pay above the market price to settle the contract they entered into.
On the other hand, if the futures price increases before the expiration date, the seller will lose out, since they previously agreed to sell the futures at a lower price as struck at the time the contract was entered. Buyers make money when the price increases before the expiration date. Their profit is the difference between what they agreed to pay under the futures contract agreement, and what the fair market value of those futures is now.
Tip: Investors who sell a futures contract profit if the underlying asset falls in price before the expiration date, but buyers earn money if the price increases before the expiration date.
Why Do Investors Trade Futures?
Investors trade futures for several reasons:
1. Futures Can Be Cheaper Than Stock
It can be less expensive to trade futures than to buy stock outright. Commissions on futures trades are quite low and only charged when the contract is completed. However, many online brokerages offer free stock trading, making futures trades a little less attractive comparatively than they once were in terms of fees.
2. Investors Can Speculate On a Larger Position Size
Additionally, due to the fact that stock futures are transacted on margin, it's possible to speculate on a much larger position size than if an investor were to take a position directly in the underlying asset. There's a leverage effect at play here, although leverage works both ways; if your position moves against you, you'll be taking on higher losses than if you had simply transacted in the actual underlying asset.
3. Investors Can Invest In an Asset Without Capital
Futures can present the opportunity to invest in an underlying asset before actually having the capital to do so. For example, if an individual investor was expecting a $100,000 inheritance to be received in 3 months, and waited until that time to invest in the stock market, they would face the risk that the market rises substantially before they are able to invest those expected funds. By buying futures contracts, that same investor can effectively lock in today's stock market valuation.
4. Investors Can Hedge Themselves Using Futures
Market participants can hedge themselves using futures. Consider a wheat farmer who is expecting to harvest a bumper crop in September, but it's currently only July, and wheat prices are high. By the time the farmer's harvest is complete, wheat prices might be lower. So the farmer may sell a Wheat Futures contract and lock in today's pricing, hedging the pricing risk.
How Reliable Are Stock Futures?
Trading futures can be extremely risky. Just as traders have the outsized opportunity to make a lot of money faster with futures, they can also lose a lot of money quickly if things don't turn out the way they expect them to.
Futures can be quite volatile, although they tend to be more stable as the expiration date approaches. It's up to investors to decide whether futures are right for their portfolio. A key consideration is how much risk they can tolerate.
Some investors look at futures for clues about what direction a stock index might move in when the market opens on a particular day. Futures track stock prices around the clock, while stocks only trade and track prices during the hours of operation of the exchange they trade on.
However, futures aren't always a reliable indicator of which way stocks will actually move. They represent more of a bet that a stock or index will move in a particular direction. Sometimes traders will accurately predict the direction, but sometimes they won't.
Where Can I Check Stock Futures?
You can view stock futures at brokerages that offer trading on them, such as e*Trade, TD Ameritrade, Charles Schwab, Interactive Brokers and TradeStation.
Analystโs Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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