Futures are financial derivatives - contracts that allow for the delivery of some underlying asset in the future, but with a price determined today in the market.

Key Takeaways

  • A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price.
  • The intended reason that companies or investors use future contracts is as a hedge to offset their risk exposures and limit themselves from any fluctuations in price.
  • Because futures traders can take advantage of far greater leverage than the underlying assets in many cases, speculators can actually faced increased risk and margin calls that magnify losses.

What Are Futures?

Futures, in and of themselves, are not inherently riskier than other investments, such as equities, bonds, or currencies. That is because futures prices depend on the prices of those underlying assets, whether it is futures on stocks, bonds, or currencies! Trading the S&P 500 index futures contract cannot be said to be substantially riskier than investing a mutual fund or exchange-traded fund (ETF) that tracks the same index, or by owning the individual stocks that make up the index.

Moreover, futures tend to be highly liquid. For instance, the U.S. Treasury bond futures contract is one of the most heavily traded investment assets in the world. As with any similar investment, such as stocks, the price of a futures contract may go up or down. Like equity investments, they do carry more risk than guaranteed, fixed-income investments. However, the actual practice of trading futures is considered by many to be riskier than equity trading because of the leverage involved in futures trading.

Hedging = Less Risk

Futures contracts were initially invented and popularized as a way for agricultural producers and consumers to hedge commodities such as wheat, corn, and livestock. A hedge is an investment made to reduce the risk of adverse price movements in another asset. Normally, a hedge consists of taking an offsetting position in a related security - and so futures contracts on corn, for example, could be sold by a farmer at the time that he plants his seed. When harvest time comes, the farmer can then sell his physical corn and buy back the futures contract. This strategy is known as a forward hedge, and effectively locks in the farmer's selling price for his corn at the time he plants it - it doesn't matter if the price of corn rises or falls in the interim, the farmer has locked in a price and therefore can predict his profit margin without worry.

Likewise, when a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. Just like the farmer or company above, an investor with a portfolio of stocks, bonds, or other assets can use financial futures to hedge against a drop in the market. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an asset. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

Leverage = More Risk

Leverage is the ability to margin investments with an investment of only a portion of their total value. The maximum leverage available in purchasing stocks is generally no more than 50%. Futures trading, however, offers much greater leverage - up to 90% to 95%. This means that a trader can invest in a futures contract by putting up only 10% of the actual value of the contract. The leverage magnifies the effect of any price changes in such a way that even relatively small changes in price can represent substantial profits or losses. Therefore, a relatively small drop in the price could lead to a margin call or forced liquidation of the position.

Because of the leverage used in futures trading, it is possible to sustain losses greater than one's original investment. Conversely, it is also possible to realize very large profits. Again, it is not that the actual asset a trader is investing in carries more inherent risk; the additional risk comes from the nature and process of how futures contracts are traded. To handle the additional leverage wisely, futures traders have to practice superior money management by using prudent stop-loss orders to limit potential losses. Good futures traders are careful not to over-margin themselves, but instead to maintain enough free, uncommitted investment capital to cover drawdowns in their total equity. Trading futures contracts requires more trading skill and hands-on management than traditional equity investing.

The Bottom Line

Futures contracts were invented to reduce risk for producers, consumers, and investors. Because they can be used to hedge all sorts of positions in various asset classes, they are used to reduce risk. Because speculators can use a greater degree of leverage with futures than with ordinary stocks, they can magnify losses, making them more risky. So are futures risky? It all depends on how they are used.