What Are Futures and What Are the Risks?

In the movies screenwriters like to flag a high-flying investor with terms like "pork futures" or "soybeans are up." It was a key plot point of the 80's classic "Trading Places," when Dan Akroyd and Eddie Murphy's characters use frozen orange juice to ruin the film's Wall Street villains.

Well, if you've ever wondered exactly how the guy from "Ghostbusters" managed to weaponize a breakfast drink, the answer lies in the nature of futures.

Futures are a form of sophisticated trading on the commodities market. They are the building blocks of commodities trading and required reading for any sophisticated investor. They are also extremely risky for the retail investor.

What Are Futures?

Futures are an investment made against changing value. In a futures contract, you agree to either buy or sell an asset for a set price at a set date. This is a binding agreement. Historically futures have dealt in commodities, which are raw, physical goods such as pork, crude oil, gold or other tangible goods. Modern futures contracts cover virtually any tradeable asset, including stocks, bonds and cryptocurrencies.

The traditional futures contract is one for physical delivery. If you take a position in crude oil futures and neither sell nor close out the contract, at the expiration date you will own thousands of barrels of oil in a warehouse. While many traders still rely on this aspect of the futures market, the growth of commodities as a financial vehicle has seen contracts diversify into entirely cash transactions as well.

Futures Contract Structure

The structure of a futures contract involves the following elements:

1. Long or Short Position

Your futures contract specifies either that you will buy the asset, which is called taking a "long position," or that you will sell the asset, which is called taking a "short position."

In a long position contract, the other party agrees to acquire and then sell to you the asset. In a short position contract, you agree to acquire and then sell to the other party the asset.

2. Strike Price

The price at which you will buy the asset or the price for which you will sell it.

3. Expiration Date

The date on which this future transaction will take place (hence the term "futures contract").

4. Asset and Quantity

The asset you are trading and how much of it you will buy or sell. Depending on the nature of the asset this section might also specify quality, grade or other details. For example, a contract for gold might specify the quality of metal, while one for stocks might specify share class.

5. Physical or Cash Settlement

A physical settlement involves actual delivery of the asset. At the expiration date, unless you dispose of the contract, you will either receive the asset or be expected to acquire and sell it.

A cash settlement (or financial settlement) does not anticipate physical delivery. Instead, it specifies that at expiration the parties will exchange the cash value of the contract.

Value of a Futures Contract

The value of a futures contract is in the difference between a commodity's trading price and its strike price at the expiration date.

A long trader wants the asset to increase in value by the expiration date so they can buy the asset for less than it's worth. A short trader wants the asset to decrease in value so they can sell the asset for more than it's worth.

A successful trade, one in which your contract is profitable, is called being "in the money." One in which the contract is unprofitable is called "out of the money."

Examples of Futures Trading

Let's take a look at two contracts in action.

Case One: Sam enters a futures contract to buy (long position) 100 shares (quantity) of Apple (AAPL) stock (asset) on July 1 (expiration date) for $210 per share (strike price), with delivery of the shares unless he closes his position (physical settlement).

On July 1 the price of Apple shares has reached $215. Sam's contract is in the money, because he has the right to buy these shares for less than their price. The value of his contract is $5 (the difference between his strike price and the asset price) times 100 (the quantity): $500. He can either close out his position for $500 or accept delivery of the inexpensive shares in hopes that they will increase further in value.

Case Two: Elizabeth enters a futures contract to sell (short position) 1,000 barrels (quantity) of crude oil (asset) on Aug. 15 (expiration date) for $90 per barrel (strike price), with no delivery of actual assets (cash settlement).

On Aug. 15 the price of crude oil has risen to $100 per barrel. Elizabeth's contract is out of the money, because her strike price is less than the asset's current price. The value of this contract is negative $10 (the difference between her strike price and the asset price) times 1,000 (the quantity): negative $10,000. Since this is a cash settlement, Elizabeth does not have to actually acquire and then sell the oil. Instead she owes $10,000.

What Are the Risks of Futures?

Unlike more traditional financial products, a futures contract can lead you into debt. Traditional financial investments, such as stocks and bonds, have front end risks. This means that you establish your maximum exposure when buying the investment. If you buy $1,000 worth of stock, for example, you could potentially lose all of that money but will never end up owing more than that initial payment. This gives you complete control over your risk profile.

Futures have back-end risks. When buying a futures contract you put relatively little initial money down. The costs and rewards are not established until the contract's expiration date, at which point both parties discover their outcome.

This means that you have very little control over your risk profile. If an asset's value surges or collapses in value, you can end up owing an enormous (and unforeseeable) amount of money on this contract.

This makes futures contracts extremely dangerous for the retail investor. Unless you have the assets to cover significant losses a series of bad trades can wipe out not just your portfolio but your personal finances as well.

Closing Out Futures

There are two ways to end your position in a futures contract before its expiration date.

The first is to sell the contract to someone else. This will end your position, although it doesn't end the contract.

The second, and more common method, is called "closing out."

Closing out of a position in the futures market means taking out an equal but opposite contract to your existing one. To close out of a long position you would take a short position with the same strike price, expiration date and assets. To close out of a short position you would do the same thing with a long contract.

Since a trader cannot have identical long and short positions open at once, the futures exchange will compare these two contracts and declare your position "flat."

While closing out can limit your losses on a future contract that looks like it will expire out of the money, it has limits. To close out your contract you must find a broker willing to sell you an equal-but-opposite contract. For imminent expiration dates or tenuous market positions, this may be difficult.

Non-Financial Uses of Futures

A futures contract has two main functions.

The first is as a financial vehicle. As discussed above, traders use futures contracts to speculate on the future value of assets. They build investments around predicted swings in value, and their goal is to make money off accurate speculation.

The second purpose of the futures market, and the one for which it was invented, is price stabilization. Businesses which rely on either buying or producing a long-term supply of raw goods use futures contracts so that they can set their prices in advance. This gives them certainty and insulates them from having to adapt to random fluctuations in asset prices. This is called hedging, and it is typically used as a loss-prevention technique rather than as a profit center.

Hedging almost always involves physical settlement contracts.

Examples of Hedging

Case One: Roger is a farmer. He enters a short position to sell 1,000 bushels of corn on Sept. 1 for $3.40 per bushel.

Roger does this to hedge against a collapse in the price of corn on the open market. Even though he risks losing profits if the price of corn goes up, Roger can now predict his cash flow later in the season and has established a minimum income for his farm.

Case Two: Samantha runs a chain of coffee shops. She enters a long position to buy 1,000 pounds of Arabica coffee beans on Sept. 1 for $2 a pound.

Samantha does this to hedge against a surge in the price of coffee on the open market. Even though she risks losing a better deal if the price of coffee drops, Samantha can now budget for her inventory in September and has established a maximum product cost for her shops.

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