What to know about futures contracts - and the 5 reasons why investors trade them

• Futures are financial contracts that investors can use to speculate on the direction that certain assets will move.
• Futures contracts can derive their value from several different asset types like commodities, currencies, stock indexes, and agricultural items.
• Investing in the futures market is considered highly speculative because of their low margin requirements and volatility.

Much of the investing landscape is based on how an investor feels about the economic landscape and the ways in which that investor can profit or protect themselves. If you believe in a company's ability to succeed, perhaps you might buy the stock or a call option.

If you're pessimistic about a company's outlook, you may consider put options. A futures contract is another financial tool that traders can use to speculate on the price swings of assets like oil, gold and other commodities.

But what exactly are futures, how do they work, and what sets them apart from options?

What are futures?

Futures are contracts where the buyer agrees to buy a commodity or financial instrument a particular the quantity, price, and date at a later point in time - and the seller agrees to sell or deliver the asset. Futures are derivatives, which means that their value is derived from an underlying asset. For example, a futures contract on crude oil will be heavily influenced by the price fluctuations of the oil market.

Futures contracts can be critical for businesses that depend on certain input goods to operate. The airline industry is well-known for this, because of the fluctuating prices for jet fuel, and uses futures contracts to lock in prices and protect against unexpected costs.

While futures contracts based on commodities like corn, oil, and wheat are the most common, there are several other asset types that a futures contract can derive its value from. Here's a short list:

• Commodity futures: Commodities are tangible assets, agricultural products, and natural resources used in commerce and trade. A short list of futures in this category would include soybeans, corn, wheat, crude oil, and natural gas.
• Precious metal futures: Gold and silver are the most common metals that fall into this category. Investors who purchase futures contracts on gold or silver are usually looking to hedge against global financial uncertainty, inflation, or geopolitical events.
• Stock index futures: Futures contracts can also derive their value from an index like the S&P 500, Nasdaq, Russell 2000, or Dow Jones. Investors use stock index futures to capitalize on anticipated movements in an index and can be sensitive to events like data releases, such as the US jobs report or statements by the Federal Reserve.
• Currency futures: These types of futures contracts can be based on the exchange rates between countries. Some of the most popular currency futures contracts include the Canadian dollar, British Pound, Japanese Yen, and Euro.
• US Treasury futures: The interest rates on Treasury bonds have a significant impact on a large part of the financial markets. US Treasury Futures allow investors to speculate on the potential changes in interest rates.

Quick tip: Treasury futures are not available for every type of treasury bond. Only 2-, 5-, 10-, and 30-year bonds are used for futures contracts.

Understanding how futures work

There are five key parts to every futures contract, also known as standard contract specifications.

• Trading hours: Unlike the US stock market, which is open from 9:30 a.m. to 4 p.m. ET, futures trade almost 24 hours a day, six days a week, starting on Sunday at 6 p.m. ET. The closing time varies between 5 p.m. and 6:45 p.m. ET on Friday, depending on the type of contract you're trading.
• Contract size: Each type of contract has a predetermined size. One contract of gold will always equal 1,000 troy ounces - a unit of measure used for weighing precious metals - while one contract of S&P 500 futures will be $50 times the S&P 500 index. (So, for example, if the S&P 500 is trading at 2,300, the value of the contract would be $115,000 [$50 x 2,300]).
• Contract value: The contract value is the current price of the contract. If gold is trading at $1,500 per ounce today, then the contract value would be $150,000.
• Tick size: This is the smallest denomination that a contract can fluctuate and varies depending on the type of contract.
• Delivery method: Futures contracts can be financially settled or physically settled. From the investor's perspective, these are usually financially settled, whereas businesses may choose physically settled contracts.

Quick tip: Some brokerages do not allow for physically settled futures contracts and will close the contract on your behalf if you do not do it manually. This protects the investor from receiving large quantities of unwanted items.

Futures contracts can be purchased on margin, meaning that an investor only needs to put in a small amount of money to control a much larger sum in the market. The minimum amount of money required to enter into a futures contract is known as the initial margin requirement.

These requirements are set by the futures exchange and are subject to change. Generally, the margin requirement for futures contracts is between 3%-12%. This means, depending on the price of the contract, an investor could spend $5,000 of their own cash to control a $100,000 investment, which represents only 5%.

This amount of leverage can present serious risks if the investment does not go as planned and in some cases could cause an investor to lose more than the initial amount invested.

Quick tip: Micro E-mini index futures began trading in 2019. This allows investors to enter into futures contracts on a stock index at a much lower price point. These micro futures are 1/10th the size of the standard index futures.

5 reasons investors trade futures

1. Diversifying: Adding futures to your investment portfolio can help you gain exposure to different types of asset classes that aren't as widely available in the stock, bond, and options markets.
2. Speculating: Investors who have an appetite for speculation may see significant gains (or losses) much quicker than in other markets.
3. Hedging: Companies use futures contracts to mitigate the risk of unexpected changes in price. "This works particularly well for anyone that needs to control input prices for a product," says Dominique Henderson, Certified Financial Planner and owner of DJH Capital Management. If prices are rapidly increasing for a commodity, a futures contract can lock in current prices and help preserve profits.
4. Earning tax benefits: Some futures trades can qualify for preferential tax rates using the 60/40 rule: 60% of the profits will receive long-term capital gains treatment, and the remaining 40% will be treated with short-term capital gains. This is a unique structure compared to short- and long-term gains with stocks.
5. Short selling: Short selling is the process of profiting from downward movements in the market. For stocks, short selling usually has higher margin requirements than long positions. But with futures, the margin requirement is the same for both long positions and short positions. This means that the investor can risk less of their cash on-hand for short selling positions with futures than with stocks.

Pros and cons of futures

As with any investment vehicle, there are pros and cons that you should be aware of. These are some of the major advantages and disadvantages.

Futures vs. options

Futures and stock options have many similarities - both are contracts between two parties and can allow an investor to hedge and protect their portfolio - but there are some key differences that you should be aware of.

The financial takeaway

Investing with futures can be a way to diversify your portfolio in ways that the more traditional stock and bond investor can't. This additional exposure comes with a few trade offs which include higher rates of volatility, longer trading hours, and special tax advantages.

"Futures tend to be a more complex or advanced financial instrument," adds Henderson. While the potential for large profits may be tempting, carefully consider the risks before entering into futures trading. It may also be wise to consult a Certified Financial Planner to ensure that a negative move in the futures market does not threaten your overall financial security.