Investing in the stock market can make money, secure your retirement, or build wealth to pass on a legacy to your children. We’ve found that most people are familiar with buying stocks.
Stocks are an equity investment because when you buy a stock, you buy a percentage of ownership in a company. You trade stocks on a stock exchange through a broker or online investment site.
Futures are another way to invest. Investing in futures is similar to investing in an equity stock but also different. You buy futures on a futures exchange, similar to a stock exchange.
Popular exchanges include the Chicago Board of Trade and the New York Mercantile Exchange. However, you aren’t buying shares in a company when you buy futures.
Instead, you are signing a contract requiring you to buy or sell an asset at a specific price on a predetermined date. The time horizon for investing in futures also differs from that of stocks. Stock market investments generally work best over the long term, while futures typically mature over the short term, usually less than one year.
Futures receive their name based on the maturity month; for example, a Feb. future matures in February. Stock futures, also called index futures or equity futures, are one type of future.
Types of Index Futures
Index futures offer an opportunity to participate in a potential future price increase of a stock index without buying the stocks in the index.
One of the largest indexes is the S&P 500, which broadly represents the market. Traders invest in S&P 500 futures by buying E-mini S&P 500 futures contracts. Traders can also invest in Nasdaq futures, based on the movement of the Nasdaq indices, Russell Futures, or Dow Jones Futures, based on the movement of the Dow Jones Industrial Average (DJIA).
Nasdaq exchanges typically represent tech stocks, while the DJIA represents blue chip companies across many sectors. Russell Futures are based on the Russell 2000 Index, a small-cap US index. Futures exist on foreign indexes, such as the Eurex, as well.
| Type of Index Futures | Description | Examples |
|---|---|---|
| Equity Index Futures | Futures contracts based on stock market indices, representing the overall stock market performance |
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| Sector Index Futures | Futures contracts based on specific sectors of the stock market |
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| Volatility Index Futures | Futures contracts based on market volatility indices, such as the VIX (Volatility Index) |
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| International Index Futures | Futures contracts based on stock market indices of other countries |
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Selling a Stock Futures Contract
By opening a brokerage account, you can sell a contract to another investor at its fair value. Fair value is a theoretical calculation that considers the index’s current value, dividends paid to stocks on the index, days remaining before the contract’s expiration, and current interest rates.
See Related: How to Invest in Stocks: A Comprehensive Guide
An Example of A Stock Future Contract
Suppose you enter a contract to speculate on S&P 500 prices in December. E-mini S&P futures are priced at $50 times the index value, and you buy the futures contract when the index trades at 1,000 points.
Your contract has a market value of $50,000 or $50 times 1,000. You put up 25 percent of the contract’s value as a deposit, or $12,500. The contract is to settle in March, which means it is a March futures contract.
If the S&P index is 900 points in March, the contract’s market value is $50 times $900, or $45,000. You’ve lost $5,000. If, however, the index rises to 1100 points, the value of the contract is $50 times 1,100 or $55,00. You’ve earned $5,000.
Pros and Cons of Trading in Futures
Like any trading, stock futures trading has pros and cons.
Pros
The benefits of stock futures trading include
- Traders can speculate on the predicted future value of indexes without buying all the stocks in the index.
- Investors can use the futures to hedge their portfolios against losses or unfavorable price changes.
- Traders can enter into a futures contract by depositing only a fraction of the amount with the broker. The deposit is called a performance bond.
- Futures contracts are very liquid, meaning you can sell them quickly.
Cons
Futures trading, however, has some disadvantages.
- Prices are often volatile and could break against you, meaning you’ll lose money.
- Trading on a margin is risky. While leveraging your contract purchase can be an advantage, it can also be a disadvantage. If you contract to buy an asset whose price falls and remains low at maturity, you’ll have to come up with the additional cash. Also, even though you may only have to make a small deposit initially, the brokerage firm can require you to increase your deposit amount if the contract’s value changes. When brokerage firms require you to increase the deposit amount, they issue a margin call.
Frequently Asked Questions
Are Futures Derivatives?
Yes, futures are a type of derivative. Derivatives are contracts whose values depend on an underlying asset’s value. Futures are based on the future predicted value of assets such as stock market indexes, agricultural or natural products, currencies, or precious metals.
Are Stock Futures a Good Investment?
Stock futures can be an excellent investment, depending on your goals. Buying futures contracts requires less initial capital than buying stocks, so investing in futures can allow you to benefit from how stocks perform without tying up too much capital.
They also can help you hedge against price decreases if you sell an asset because the contract allows you to lock in a specific price. You can also usually sell a futures contract quickly if necessary.
However, futures do carry some risks. If the underlying asset declines in value, you’ll have to pay the higher original price and lose money.
How Do Stock Futures Differ from Commodities Futures?
Stock futures are based on how stock market indexes perform. At maturity, investors settle with cash rather than stock or another asset.
On the other hand, commodity futures are contracts where traders agree to buy or sell a tangible commodity, such as gasoline or corn, at a specific price at a set future date. The asset changes hands for the agreed-upon price at the end of the term. Businesses also use commodities futures to lock in raw materials prices.
How Do Futures Contracts Differ from Options?
Futures contracts are legally binding. You must settle the contract regardless of favorable market conditions on expiration or maturity date. However, if you have an option, you may choose to exercise the option or not.
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