Updated: Sep 21, 2020
Futures are contracts that derive value from an underlying asset such as stock, stock index (for e.g. S&P500 index), interest rates (for e.g. 10-year Treasury bond) or other commodities such as gold, crude oil, wheat, corn or soybeans.
Futures are known as derivatives contracts, since their value is derived from the underlying asset that will be delivered. They allow hedgers and speculators to trade the price of the asset that will settle for delivery at a future date in the present. Futures are standardized and traded on highly regulated exchanges, making them highly transparent and liquid.
Benefits for Organizations
Future contracts are important for hedging different risks. Companies engaged in foreign import - export trade use futures to manage foreign exchange risk. Companies deciding on future investments may decide to hedge interest rate risk, locking in interest rate futures such as treasury bonds in anticipation of a Central Bank announcement to drop rates. Organizations also buy future contracts in market indexes to hedge against stock market fluctuations, or lock in futures contracts for crude oil, agricultural crops, or precious metals.
Futures and derivatives help increase the efficiency of the underlying market as they lower the unforeseen costs of purchasing an asset. For example, it is much more efficient and less expensive to go long in S&P 500 futures than to replicate the index by purchasing every stock in the index. The introduction of futures markets would decrease risk, increase the trading volumes thereby increasing liquidity and reducing transaction costs when used risk management vehicles.
Future prices also give indications of market expectations. In case of political instability that may likely cause a shortage in supply of crude oil to fall, short term oil prices will rise and those with later maturities may remain at pre-crisis levels as supply is expected to normalize eventually. Future contracts therefore enhance liquidity and information dissemination leading to higher trading volumes and lower volatility.
Benefits for individual traders / investors
Future contracts, because of the way they are structured and traded, have many inherent advantages over trading stocks.
Futures are leveraged investments
Investors use margin for futures, this is considered a collateral or performance bond that the investor has to keep with exchange in case the market moves opposite to the position he has taken and he incurs loses. By using this leverage, the investor can be exposed to a lot more stocks than he/she could if the stocks were bought instead.
Assuming the investor takes 10% margin to purchase Apple Inc. stock (APPL) priced at $383, he can either buy 10 stocks or a future contract holding 100 Apple stocks (10% margin for 100 stocks: $3830). Now assuming a $1 increase in price of Apple, the investor would earn a profit of $10 if he/she invested in stocks but if he/she bought a future contract, the profit would be $100.
Future markets are liquid
Future contracts are traded in vary large numbers every day therefore are very liquid. The many buyers and sellers in the future markets ensures market orders can be transacted quickly and that prices do not fluctuate drastically, especially for contracts that are near maturity. Large positions may be cleared out quite easily without any adverse impact on prices. Future markets also traded beyond the traditional stock exchange hours, some even trade 24/7 with short breaks during the trading week.
Futures have low commissions and executing costs
Commissions on future trades are charged when the transacted position is closed, it can be as low as 0.5% of the contract value, depending on service provided by the broker.
Speculators can make trades quicker
Using leverage, investors can make quick capital gain in futures market compared to stock market. Futures markets tend to move quicker than spot market. However, the trading risk is also higher. Therefore, they need to be managed well.
Future markets are more efficient
futures markets tend to trade market aggregates that do not lend themselves to insider trading, as opposed to stocks.
Futures markets are concerned with supply and demand of the asset
Stock investment need detailed study into the business and management of companies while for futures contracts, investors only need to deal with supply and demand of the asset, whether it is for interest rates (bonds), indexes, currencies, or commodities