What Are Futures in US stocks?

Futures, a derivative financial instrument, is a binding agreement between the parties to trade a security or an asset at a pre-agreed future date and price. Futures are advanced financial tools marking the performance of their underlying asset. The assets can be currencies, stocks, bonds, or commodities.

A futures contract like US stock futures is a lock derivative. They seal in the rate of the underlying commodity or asset, i.e. these contracts have a termination date. Upon expiry, the buyer must receive, and the seller must provide the underlying asset at the pre-decided prices.

Navigating the Futures Market: A Guide to Types and Exchanges

Futures are accessible for trading and are traded on futures exchanges like New York Mercantile Exchange(NYMEX) or Chicago Mercantile Exchange(CME). The contract’s rate settles at the end of every trading schedule.

There are many futures agreements, where holders indulge in transactions of shares of a company. One more type is commodity futures, where the underlying asset is soybean, wheat, maize, gold, and natural gas. Stock index futures are another kind where they track S&P 500. There are also treasury bonds and silver futures, including stock and commodity futures.

Moreover, there is a difference between futures and options. The former makes honouring the agreement between two parties mandatory before the contract expires. Contract holders may or not exercise rights for the latter. With options, it is optional to honour the agreement, though the holders have the right to do so before contract expiry.

Why are Futures Used?

Futures play a fundamental role in the market. These contracts study asset price movements and estimate their future outcomes.

Investors use futures contracts to speculate on the direction of asset prices and profit from their movements. By choosing either a long or short futures contract, traders can position themselves to capitalize on anticipated price changes.

Suppose your firm expects gold prices to rise in the coming months. The company can go for a long futures contract wherein they will buy a specific amount of gold at pre-decided prices in 3 months. Your firm and the supplier must honour the agreement irrespective of whether the gold’s price exceeds or recedes the set price. Comparably, investors undertake a short futures position if they believe the asset prices will fall in future.

Investors often use hedging as a strategy to manage risk in their portfolios, helping them reduce the potential impact of asset price volatility and eliminate uncertainty. For example, if you own a flat and want to protect it from unexpected events like a fire, you could buy fire insurance as a form of hedging to mitigate potential losses.

Futures: The good and the bad

Advantages :

• Speculating the price movement of underlying assets: During covid, meat and poultry consumption saw a significant increase. And, due to supply chain disruptions, the export of soybean and maize suffered. Speculators identified a favourable ground for investing in soybean futures contracts because more meat demand and less poultry feed supply would cause the commodity’s price to rise considerably.
• Diversifying portfolio risk: With a futures contract, investors can safeguard their funds beforehand by establishing a fixed rate for a specific time. Such agreements protect them from price volatility in the market.
• Pay only a fraction of the contract amount: Investors don't need to deposit the entire contract amount. Initially, they can pay their broker a fraction of the total amount (margin amount).

Disadvantages :

• Risk of a speculative bubble: Speculation causes a spike in the stock or commodity values. It can adversely affect consumers and producers alike. Like in the case of soybean futures contracts, speculation leads to a staggering increase in the price of the raw material. It sent the entire poultry industry into a state of frenzy. Poultry farmers found soybean costly and curtailed production, and the government had to arrange alternatives to soybean, a challenge since suitable options were difficult to gather.
• Chances of Losses: When the asset price falls, stock futures guarantee the buyer pre-decided prices, protecting him from losses. However, the seller faces an unfavourable scenario. But, if the asset price rises, the contract buyer loses out on a favourable price scenario.

Do your Homework Before Investing in Futures

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Frequently Asked Questions

1. Do Future stocks predict the market?

By studying recent market trends, Future contracts estimate the expected price movements. However, the market is prone to uncertainty. Thus the contracts might not necessarily offer accurate predictions.

2. Are Futures Just Gambling?

There lies a key difference between Futures and Gambling. In gambling, the casino decides the game's rules, whereas, for future contracts, you are the decision maker. To opt for a long futures position or a short one depends on your market analysis and expectation.

3. What is the best indicator of US stock market?

The S&P 500 and Dow Jones Industrial Average are prominent indicators of the US stock market, representing a broad range of companies. The Nasdaq Composite index specifically tracks technology and growth-oriented firms.