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What Are Futures?

What if there were a way to make money from the up-and-down movement in the prices of financial assets without actually owning the asset? Well, there is a way- with futures. If you’re an Average Joe or Jane just looking to put aside money for retirement and watch it grow, getting in to futures might be overkill. But here’s some information so you’ll know how it works. 

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What Is a Futures Contract?

A futures contract is an agreement to buy or sell something at a future date, for an agreed-upon price. That “something” can be a commodity, a currency, a bond or a stock. A futures contract on a stock is known as a stock market index future. A futures contract can be for the asset itself (a herd of cattle), or be a contract on the original contract. In the latter case, it would be considered a derivative because it’s a financial product whose value is based on an underlying asset. These days, most investors in futures are not buying the underlying asset (the commodity, for example). If you succeed in the futures market, you’ll get cash, not a six-month supply of aluminum.

How the Futures Market Works

The futures market is the home of exchange traded futures contracts. At the basic level, a futures contract is an agreement between, say, a producer and a manufacturer. The producer wants to lock in the selling price and the manufacturer wants to lock in a buying price. So they agree on a futures contract so that each of them has advanced knowledge of what they’ll pay (or receive) down the road, at a future date.

 

What Are Futures?

When that future date arrives, one party will have lost and the other will have won. For example, the buyer might kick himself for locking in a price because prices have fallen, or the seller might kick herself because prices have risen. But both parties agreed that hedging against risk with a futures contract was better than waiting. The futures market as it exists today isn’t just made up of the buyers and sellers of original commodities, but also includes the buying and selling of those futures contracts.

The wins and losses on the futures market fluctuate from day to day depending on the price of the commodity (or bond or stock or currency) that is the basis of the futures contract. If you’re party to a futures contract, your account will be debited or credited according to each day’s price change. A reminder: futures trading creates winners and losers. One person goes long (profits if the price rises) and one person goes short (profits if the price falls). Whoever speculated correctly about how the price would move is the winner. It’s a zero-sum game.

Related Article: How to Make Smart Investments on a Small Budget

Trading on Margin

“Margin Call” is more than just the name of a Kevin Spacey movie. It’s a term that anyone considering investing in futures should know. When you invest in the futures market, you’ll give a broker access to a set margin, usually expressed as a percentage of the value of the futures contract. That amount will help cover any losses you sustain as prices fluctuate. Remember, the value of your holdings will grow and shrink depending on how your position performs in the futures market.

If you sustain big losses that eat into your margin, your broker will make a “margin call” requiring you to top up your margin and bring it back up to required levels. That’s because a certain amount of margin must be maintained throughout the life of the contract in order to minimize the credit risk that the futures exchange take on. So, you may think you only ponied up the money for your initial investment, but a margin call could leave you forking over even more money.

Futures Brokers

Any person or company taking customer money to deal in futures must register with the National Futures Association (NFA). The US Commodity Futures Trading Commission (CFTC) oversees the NFA and the futures market. The CFTC lists the following futures fraud warning signs:

  • Schemes that sound too good to be true, with promises of fast and astronomical returns.
  • Guarantees of big profits, with limited information to back up the firm or broker’s claims.
  • Promises of low or no risk.
  • Claims relating to currency trading on the “interbank market.”
  • Cold calls from strangers wanting to pitch investment opportunities.
  • Requests for immediate transfers of funds.

You’ve heard of a Ponzi scheme, right? Well, commodity futures are often what folks operating Ponzi schemes will pitch to investors. It’s a good idea to check the NFA registration and disciplinary history of anyone who wants to sell you on futures. As always, it’s important to do your research before investing your hard-earned dollars.

Related Article: Four People Who Single-Handedly Caused Economy Crises

Bottom Line

 

What Are Futures?

In general, it’s unusual – and risky – for an individual who isn’t a finance professional to get involved in the futures scene. If you’re thinking of taking the plunge, it’s a good idea to educate yourself thoroughly and consult resources from the NFA and CFTC to help you vet brokers. If you decide not to buy individual futures contracts, there are mutual funds and Exchange Traded Funds (ETFs) that can give you access to the futures market. These, too, will need to be vetted. Good luck!

Photo credit: flickr, ©iStock.com/scyther5, ©iStock.com/dolgachov

Amelia Josephson Amelia Josephson is a staff writer covering financial literacy topics at SmartAsset. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.

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