What are Futures Contracts?

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Have you ever heard the business TV reporters say that "The futures are up this morning" and wondered what they meant?  I'll answer that soon and describe what the futures market is and how traders and even some investors use futures contracts.

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You're aware of the Stock Market and the Bond Market, but did you also know there's a Futures Market too?  Or more precisely, there are futures contracts that trade for many different contracts, including stock market index futures, bond market futures, currency futures, and even individual stock futures!  If you're familiar with how options work, then it's easy to understand what futures contracts are and how traders use them.

Let's first go back in time to why the futures market was created.  Originally, futures contracts referred to positions taken to lock in prices for farmers and producers using mostly agricultural products.

Let's pretend we're a farmer and we grow corn for a living.  We have to buy corn seeds, plant them, grow them, eventually harvest them, and finally sell the ears of corn at the market.  As farmers, we naturally want to buy the corn seed as cheaply as possible and then sell the harvested corn at the highest price possible.

The problem is that every corn farmer wants to do the same thing at the same time, which means that all farmers bought their corn seeds at the same time and then they all tried to sell their harvested corn at market at the same time.

Therein lies a problem - according to supply and demand, the corn seed price would rise when all the farmers tried to buy it and then when all the farmers tried to sell the corn at the same time, the price would decline due to the high supply of corn.

What if there was a way to normalize corn prices and remove these seasonal tendencies?  That's where the futures market comes in.  Farmers and companies who buy corn can turn to the futures market either to lock-in a future buy order at a low current price, or else lock-in a future sell order at a current high price for their crop.

Originally, futures contracts were intended for producers and consumers of agricultural products, but over the years, the futures market has expanded to include both active intraday traders and even longer-term investors.

Also, futures contracts go well beyond agricultural products, and you can buy or sell futures contracts for gold, crude oil, natural gas, the US Dollar Index, the S&P 500, the Euro, and even cattle!

Today, if you want to trade a futures contract, it's done the same way you would buy or sell an options contract.  If you believe the price of the underlying - which is a term we use for the market such as corn, oil, or even the S&P 500 - will be higher in the future, then you would buy a futures contract.  If you believe let's say the S&P 500 will be lower in the future than it is right now, then you would sell a futures contract similarly to how you would sell an option or sell-short a stock.

In a way, buying a futures contract is like making a bet that the price will rise in the future, and if it does, then you'll make money.  Thus, selling a futures contract - like selling short a stock - is like making a bet that the price will decline in the future.  If so, you'll make money.  However, if you buy a futures contract and the underlying market declines in price, you'll lose money.  Futures contracts, like options, are derivatives of their underlying market, such as corn, wheat, gold, or silver.

Like options, futures contracts all have an expiration date so you'll need to know when a contract you trade will expire.  Like options, you can buy a short-term contract or a longer term contract.

In reality, a futures contract is an agreement to purchase or sell a certain amount of an underlying product at a certain date in the future.

The biggest fear that comes up when a new trader starts dabbling in the futures market is worrying that one day, hundreds of barrels of crude oil will magically appear at their front door!

The truth is that most traders never take possession because they don't hold a futures contract all the way to expiration.  Traders use them purely for price speculation for profit, usually trading based off technical analysis or very short-term fundamental analysis or even news-related events.

For most traders, futures contracts are a simple way to use leverage for pure speculation.  You can think of futures contracts today as you would an Exchange Traded Fund, or ETF.

Just as there are specific ETFs for all markets such as GLD for Gold, SLV for silver, UUP for the US Dollar Index, and SPY for the S&P 500, each market would have a corresponding futures contract.  For example, the symbol for gold futures is GC.  The symbol for silver is SI.

For all practical purposes, think of futures contracts as you would ETFs.  Futures are sort of like a combination between an ETF and an options contract.  While an ETF does not expire, both futures contracts and options do expire at a set date.

Stay tuned for our next episode were we dig a little deeper into how traders today use futures contracts, and what it means when you hear on TV that "the futures market is up today."

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