Futures Contracts Explained

Futures Contracts Explained

Many investors choose to avoid trading in futures simply because they don’t understand the market. This can prove to be a big mistake on their part, because when futures trading is done properly, it can deliver significant rewards.

To understand the futures market, you have to understand futures contracts. When you buy or sell a future, you’re not buying and selling the stock certificate, and this is where many people get confused; what you’re actually doing is entering into a stock futures contract. This is an agreement to buy or sell the stock certificate at a set price on a preordained date.

There are a few important ways in which futures differ from traditional purchases. Firstly, you never own the stock, which means that you won’t receive dividends or be entitled to a place at stockholder meetings. Secondly, and importantly, you can make money not only when your stock rises, but also when it falls.

How It Works: Long and Short Positions

In stock futures, two basic positions exist: long and short. If you choose a long position, this means that you agree to buy the stock once your contract expires. Conversely, when you take a short position, you instead agree to sell the stock when the contract ends.

So what does this mean in real terms, and how does it affect your trading decisions? It’s much simpler than you might think.

If you believe that the price of a stock will increase, you want to take a long position. Lets imagine that in January you enter into a futures contract to buy 10 shares in XYZ on 1st March at $50 per share. Your contract would be worth $500. If the market value of the stock went up before this date, you would be able to sell the contract early and make a profit. If the price rose by just $2 per share, you would be able to net $20 profit. This is an example of going long.

If you think that it will decrease, then it’s better to go short. Lets imagine that you enter into a contract with the same terms, only this time you must sell the shares on 1st March. This time, the value of your stock drops to $48 per share by the deadline date. However, your strategy means that you’ve bought the contract back before you have to deliver the stock, thus spending $480 on a contract worth $500. This is an example of successfully going short.

Buying on Margin

When you buy or sell futures contracts, it is different to other forms of trading in that you only pay a percentage of the price of the stock. This is known as buying on the margin, and a typical margin is around 10 to 20 per cent of the full value of the contract.

So how does this work in practice? Lets use our XYZ stocks to demonstrate. Our contract is worth $500. If we buy on the margin at 20 per cent, we only actually hand over $100. If we’ve gone long and the stock price rises, we make $20, a 20 per cent gain on our initial margin investment. However, if we get things wrong, and the prices drop, we’d have to sell for a 20 per cent loss on the money we initially invested instead.

And that, ladies and gents, is how futures contracts work. Now that you understand them better, could futures contracts spell the future for your investment portfolio? For more information on futures contracts, contact a reliable financial broker.