How Stock Futures Work


A stock future is a contract to buy or sell a specific amount of stock for a certain price on a set future date. See more banking pictures.
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In the past couple of years, the U.S. stock market has been volatile. But stock futures are one way to hedge your investments so that no single market fluctuation -- way up or­ way down -- will ruin your portfolio.

The best way to understand how stock futures work is to think about them in terms of something tangible. Let's say you own a popcorn company and you need to buy corn to make your product. Every business day, the price of corn goes up and down. You want to buy corn for the lowest price possible so you can make the most profit when you sell your finished product. But you realize that the price of corn today might be very different than it is a year from now. So you enter into a futures contract with a farmer to buy his corn at a specific price on a certain future date.

The farmer needs to make money, too, so he's not going to agree on a price that's way below the current market value. So you'll agree to a fair price to ensure that both of you will be happy with the transaction in a year. It won't be the highest or the lowest price, but neither one of you will get pounded by drastic market fluctuations.

Stock futures work in much the same way. Two parties enter into a contract to buy or sell a specific amount of stock for a certain price on a set future date. The difference between stock futures and tangible commodities like wheat, corn, and pork bellies -- the underside of the pig that's used to make bacon -- is that stock future contracts are almost never held to expiration date. The contracts are bought and sold on the futures market -- which we'll explore later -- based on their relative values.

In the United States, you can buy and sell single stock futures or stock index futures -- contracts based on the performance of an index like the Dow Jones Industrial Average or the S&P 500.

Let's learn more about futures contracts.

Futures Contracts 101

Traders signal offers in the Wheat Options pit at the Chicago Board of Trade.
Traders signal offers in the Wheat Options pit at the Chicago Board of Trade.
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When you buy or sell a stock future, you're not buying or selling a stock certificate. You're entering into a stock futures contract -- an agreement to buy or sell the stock certificate at a fixed price on a certain date. Unlike a traditional stock purchase, you never own the stock, so you're not entitled to dividends and you're not invited to stockholders meetings [source: Thachuk]. In traditional stock market investing, you make money only when the price of your stock goes up. With stock market futures, you can make money even when the market goes down.

Here's how it works. There are two basic positions on stock futures: long and short. The long position agrees to buy the stock when the contract expires. The short position agrees to sell the stock when the contract expires. If you think that the price of your stock will be higher in three months than it is today, you want to go long. If you think the stock price will be lower in three months, then you'll go short.

Let's look at an example of going long. It's January and you enter into a futures contract to purchase 100 shares of IBM stock at $50 a share on April 1. The contract has a price of $5,000. But if the market value of the stock goes up before April 1, you can sell the contract early for a profit. Let's say the price of IBM stock rises to $52 a share on March 1. If you sell the contract for 100 shares, you'll fetch a price of $5,200, and make a $200 profit.

The same goes for going short. You enter into a futures contract to sell 100 shares of IBM at $50 a share on April 1 for a total price of $5,000. But then the value of IBM stock drops to $48 a share on March 1. The strategy with going short is to buy the contract back before having to deliver the stock. If you buy the contract back on March 1, then you pay $4,800 for a contract that's worth $5,000. By predicting that the stock price would go down, you've made $200.

What's interesting about buying or selling futures contracts is that you only pay for a percentage of the price of the contract. This is called buying on margin. A typical margin can be anywhere from 10 to 20 percent of the price of the contract.

Let's use our IBM example to see how this plays out. If you're going long, the futures contract says you'll buy $5,000 worth of IBM stock on April 1. For this contract, you'd pay 20 percent of $5,000, which is $1,000. If the stock price goes up to $52 a share and you sell the contract in March for $5,200, then you make $200, a 20 percent gain on your initial margin investment. Not too shabby.

But things can also go sour. If the stock price actually goes down, and ends up at $48 a share on April 1, then you have to sell the $5,000 contract for $4,800 -- a $200 loss. That's a 20-percent loss on your initial margin investment. If the stock drops considerably, it's possible to lose more than the price of the initial investment. That's why stock futures are considered high-risk investments.

When buying on margin, you should also keep in mind that your stockbroker could issue a margin call if the value of your investment falls below a predetermined level called the maintenance level [source: Money.net Inc.]. A margin call means that you have to pay your broker additional money to bring the value of the futures contract up to the maintenance level.

Now let's look at some of the most common investment strategies using stock futures.

Stock Future Investment Strategies

A mad rush ensues at a Chicago Cattle Futures pit upon the discovery of a Mad Cow outbreak in Iowa.
A mad rush ensues at a Chicago Cattle Futures pit upon the discovery of a Mad Cow outbreak in Iowa.
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Single stock futures can be risky investments when purchased as standalone securities. There's a possibility of losing a significant chunk of your initial investment with only minimal market fluctuations. However, there are several strategies for buying stock futures, in combination with other securities, to ensure a safer overall return on investment.

One of the most effective stock future strategies is called hedging. The basic idea of hedging is to protect yourself against adverse market changes by simultaneously taking the opposite position on the same investment.

Let's say you buy a share of traditional stock at $50. To make money with that stock, the price has to go up over time. But that's not necessarily true with stock futures. In addition to buying the stock, you could take a short position to sell the same stock on the futures market in three months. This way, even if your stock price goes down in three months, you'll make up some -- or even more -- of the money on the futures market.

Another way to hedge stock futures investments is through something called a spread. A calendar spread is when you go both short and long -- which we learned about earlier -- on the same stock future with two different delivery dates. For example, you could enter into two different contracts involving IBM stock. In the first contract, you agree to sell 100 shares after a month. In the other contract, you agree to buy 100 shares after six months. Using this strategy, you can make money off of both short-term losses and long-term gains.

An intermarket spread involves going long and short on two different stock futures in a related market -- like gas and electric companies -- with the same delivery date. The hope is that one stock future's loss will be the other stock future's gain.

A similar technique is a matched pair spread in which you enter a futures contract to buy shares in two directly competing companies. The idea is that Microsoft's loss is Apple's gain and vice versa. If this always happened, your investments would always break even. The hope is that one future will outperform the other without necessarily inflicting equal damage on the competition.

If hedging and spreads lower the risk associated with investing in stock futures, then speculating substantially increases it. With speculating, an investor is looking to quickly cash in on market fluctuations. By investing on margin with large amounts of money, the speculator tries to predict short-term movements in stock prices for the maximum amount of gain.

In the next section, we'll look at some of the advantages and disadvantages of stock futures in relation to traditional stocks.

Stock Futures Versus Traditional Stocks

Traders at the Chicago Mercantile Exchange toss confetti to signify the end of the trading year.
Traders at the Chicago Mercantile Exchange toss confetti to signify the end of the trading year.
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The chief advantage of stock futures is the ability to buy on margin. Investing on margin is also called leveraging, since you're using a relatively small amount of money to leverage a large amount of stock. For example, if you have $1,000 to invest, you can by 10 shares of IBM stock. But with the same $1,000, you can buy a futures contract for 50 shares of IBM stock.

It's true that you can also buy traditional stock on margin, but the process is much more complicated. When buying stock on margin, you're essentially taking out a loan from your stockbroker and using the purchased stock as collateral. You also have to pay interest to your broker for the loan [source: Money.net Inc.]. The difference with stock futures is that you're not buying any actual stock, so the initial margin payment is more of a good faith deposit to cover possible losses [source: Money.net Inc.].

I­t's also much easier to go short on a stock future than to go short on traditional stocks. To go short on a futures contract, you pay the same initial margin as going long. Going short on stocks requires that you sell the stock before you technically own it. To do that, you need to borrow the stock from your broker first. You'll incur broker loan fees and dividend payments [source: Money.net Inc.].

Stock futures offer a wider array of creative investments than traditional stocks. Hedging with stock futures, for example, is a relatively inexpensive way to cover your back on risky stock purchases. And for high-risk investors, nothing is as potentially lucrative as speculating on the futures market.

But stock futures also have distinct disadvantages. The high risk factor of a stock future can be just as dangerous as it is lucrative. If you invest in stock, the worst thing that can happen is that the stock loses absolutely all of its value. In that case, you lose the full amount of your initial investment. With stock futures, since you're buying on margin, the potential exists to lose your full initial investment and to end up owing even more money.

What's more, since you don't actually own any of the stock you're trading with futures contracts, you have no stockholder rights with the company. Because you don't own a piece of the company, you're not entitled to dividends or voting rights.

Another disadvantage of stock futures is that their values can change significantly day to day. This isn't the type of security that you can purchase in January and check the price once a month. With such a high-risk security, there's a possibility that the value of your futures contract could drop like a hot potato from one day to the next. In that case, your broker might issue a margin call, which we discussed earlier. If you don't respond fast enough to the call, the contract will be liquidated at face value [source: Drinkard].

In the next section, we'll discuss some of the different methods of buying and selling stock futures.

How to Buy and Sell Stock Futures

Most people are wise to leave their stock futures investments in the hands of a trusted broker.
Most people are wise to leave their stock futures investments in the hands of a trusted broker.
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Single stock futures are traded on the OneChicago exchange, a fully electronic exchange. Individual investors, also called day traders, can use Web-based services to buy and sell stock futures from their home computers. Dozens of companies offer online brokerage accounts to individuals with small fees -- like $0.75 per futures contract -- for each transaction.

Day trading in stock futures should be limited to investors who have an in-depth understanding of how markets work and the risks involved in buying securities on margin. If you're up to the challenge, be prepared to put in significant time to research potential stock purchases and maintain margins on all existing futures contracts. You must be willing to invest many hours every day monitoring the prices of your investments to know the best time to sell or buy. This isn't like day trading in stocks, where price changes generally happen at a slower pace.

A more conservative option would be to open a managed account with a stock brokerage firm. Shop around for brokers and do your research. You need to find someone who clearly understands your investment goals. Once you establish an account, this person will be actively trading with your money. In most broker-investor relationships, the broker is given authorization to buy and sell futures without direct authorization for each trade. The advantage is that the broker is well-versed in the most effective investment strategies for stock futures. The disadvantage is that you'll have to pay a management fee for his or her services [source: Drinkard].

An even more conservative strategy for investing in stock futures is to use a commodity pool. It functions like a mutual fund, where a large group of investors pool their money in the same portfolio. The fund or pool is managed by a team of brokers with expertise in the particular commodity -- like stock futures. Commodities pools are considered safer than an individual managed account because individual investors aren't responsible for margin calls [source: Drinkard].

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Sources

  • Drinkard, Tom. Investopedia. "Surveying Single Stock Futures."http://www.investopedia.com/articles/optioninvestor/06/SingleStockFutures.asp
  • Thachuk, Rick. AllBusiness.com. "Trading single stock futures." March 1, 2001 http://www.allbusiness.com/personal-finance/investing-trading-futures/760372-1.html
  • Money.net. "Single Stock Futures" http://www.money.net/custserv/ssf_basics.php
  • Investopedia. "Futures Fundamentals: How to Trade"http://www.investopedia.com/university/futures/futures6.asp
  • Investopedia. "Futures Fundamentals: The Players"http://www.investopedia.com/university/futures/futures3.asp
  • Investopedia. "Futures Fundamentals: Strategies"http://www.investopedia.com/university/futures/futures5.asp