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January 28, 2022

What are Futures?

When you buy a stock, you instantly own that stock for the price you paid. When you buy a future, you’re buying an agreement that states you will buy or sell assets at a certain price at a certain time in the future.

The benefit to this is that the futures contract stands regardless of how the price of the underlying stock or asset fluctuates. It essentially guarantees you a rate to buy something down the line, regardless of market fluctuations. 

So what can you buy futures contracts on? Anything from physical commodities like oil or even financial instruments like stocks. Futures contracts are standardized to facilitate easy trading on something called a futures exchange, and there’s a variety of reasons investors might buy a future, like hedging their bets or speculating on markets. 

So in summary, futures are contracts that obligate buyers or sellers to transact on an asset at a date in the future at an agreed-upon price. Futures allow investors to bet or speculate on securities and commodities. Futures also let investors protect themselves from volatility in the market, letting them hedge their bets against an underlying asset they may own.

How do futures technically work?

Futures have expiration dates and set prices. Futures contracts are generally identified by their expiration dates, so you might buy a future for December of this year with a set price for an asset, say crude oil. That contract means that whoever holds it at the expiration date, agrees to the transaction contained therein. There are a ton of types of futures though:

  • Commodity futures, for oil and things like grain or wheat
  • Stock index futures, say for the DOW or NASDAQ
  • Currency futures for currencies like the dollar
  • Metal futures for metals like gold and silver
  • Treasury futures for bonds and other financial products.

If you’re a little experienced with the stock market, you might be confused about how futures are different from options. Options allow the holder the right to buy or sell an asset, but it’s ultimately their choice when their options expire. Futures, however, obligate the holder to buy or sell the asset when they expire. Options have options, Futures are set in stone.

If you check on markets every night or before they open, you’ll often see the futures price represented. This will give investors an idea of where the market will open. 

How to use futures

Futures are used for leverage. You can buy a futures contract for a small portion of the final transaction value it represents. 

The futures themselves are traded on futures exchanges, which are essentially just the markets they sell on. The exchange determines how a futures contract is settled, whether you have to physically take delivery of the asset or whether you can just settle out in cash. 

Most futures are bought and sold by traders speculating, meaning they never intend to actually take delivery of the asset their future represents. In these cases, the futures are just cashed out when they expire, meaning that however, the price has changed, the traders either pay up or get paid based on their contract.

Aside from speculation, futures are also used by investors to hedge their investments. This essentially means the investor buys a future to protect them from gains or losses in the asset down the line. In this case, they likely own the asset that they’re buying the futures for. 

A corn farmer might buy a futures contract to make sure they can sell their crop down the line. It reduces their risk and may guarantee them profit. 

And that’s essentially what a futures contract is.

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