What are Stock Futures?
A stock future is a contract to buy or sell a specific amount of stock for a certain price on a pre-set future date.
How do Stock Futures work in simple terms?
In the past two years, the stock markets have been extremely volatile. But stock futures have emerged as the best way to hedge your investments so that no single one-way movement of the stock will ruin your portfolio. Now let us try to get deeper into this and understand how stock futures work.
Let’s say you own a coffee manufacturing company and now you need to buy coffee seeds to process it and make a packeted product out of it. Every business day, the price of coffee goes up and down. You, of course, would want to buy coffee seeds at the lowest price possible and make a profit when you sell the finished product. But then you realise that the price of coffee might be very different in a year from what it is today.
So you decide to enter into a futures contract with a farmer to buy his coffee seeds at a specific price on a certain date. The farmer also needs to make money, which means he will not agree on a price that is way below than the current market value. A Future contract is where two parties agree to buy or sell a specific quantity of stock for a certain price on a decided future date. The difference between stock futures and commodities like wheat, corn and pork bellies is that stock futures are almost never held to its expiration date. The contracts are bought and sold on the exchange based on their relative values. In the United States (other countries also), you can buy and sell stock futures or stock index futures based on the performance of various sectors and that of indexes like the Dow Jones Industrial Average or the S&P 500.
Let’s make it clear. When you sell or buy a stock future, there is no issuance of any stock certificate. It is basically an agreement to buy or sell the stock certificate at a fixed price on a specific date. In a traditional stock purchase, you own a stock and shares are held in your account. You are entitled to dividends and are invited to the shareholders meeting. But in traditional stock market investing, you only make money when the price of the stock goes up. In the case of stock futures, you can make money even when the market goes down. The two most basic terms used while taking positions in stock futures are long and short.
In a long position, you agree to buy the stock when the contract expires.
In a short position, you agree to sell the stock when the contract expires.
If you are positive on the stock in the near term, then you would want to go long, and if you feel the price of the stock will decrease in coming weeks, then you should take a short position in the stock.
How positions are created? Example:
It’s March, and you enter into a futures contract to purchase 100 shares of Tesla stock at $50 a share with an expiration date of June 1. The contract is now priced at $5,000. And now if the market value of the stock goes up before June 1, you can sell the contract early to make a profit. Taking this example, if Tesla stock price raises to $52 a share on or before June 1, then for selling a contract of 100 shares you’ll fetch a price of $5,200 and profit made from this trade is $200.
What’s really more interesting about buying and selling a futures contract is that you only pay a small percentage of the price of the contract. This is called as Margin. A typical margin can vary anywhere between 10 to 20 per cent of the price of the contract. Let’s take our Tesla example. We said that you’d be buying $5000 worth contract. So for this contract, you would pay 20% of $5000, which is $1000. If the stock price rises to $52 a piece and you sell the contract for $5200, you make $200, a 20% gain on your initial margin expenditure. Sounds good right?
But remember things can also go sour. If the stock price actually comes down to $48 a share at the expiration, then you would have to sell the contract for $4800, which is a $200 loss. If the stock price comes down drastically, it is possible that you may lose more than your initial investment. That’s why stock futures are always considered as high-risk investments.
When buying on collateral margin, you should always be aware that your stock broker could issue a margin call to you if the value of your margin falls below a predetermined level. This is also known as the maintenance level. After getting such a call from the broker, you are required to pay your broker additional money so the value of the futures contract will be above the maintenance level.
Single stock futures are always risky when purchased as standalone investments. There’s a possibility that you could lose a significant amount of your money with just minor movement in prices. Hence there are several strategies we should make use to ensure a safer overall return on investment. One of the most widely used future strategies is hedging. The basic idea behind this is to protect yourself from adverse market conditions by simultaneously taking the opposite position on the same investment.
Lastly, stock futures offer a wide array of creative investments than traditional stock purchases. And for high-risk investors, nothing is as potentially lucrative as speculating on the futures market. Hence the reason for such high volume and participation in futures market daily.