What are Stock Futures?
Stock futures are financial contracts, that is, legally binding agreement between two parties, to buy and sell underlying asset (stocks in this case) of specifying quantity in a future date at a price agreed upon between the buyer and the seller. Once the stock future contract is agreed upon, both the buyer and seller are under obligation to buy or sell the underlying stock at the agreed price. The party that agrees to buy stock futures is said to take a long position. While the other party that agrees to sell the stock futures is said to take a short position.
I hope that you are not confused with the word “underlying stock”. The word “underlying” is a term used in derivative trading such as in the case of stock futures and stock options. A derivative on the other hand is a financial instrument that derives its value from the value of other asset. For instance, a stock future gives the holder an obligation to buy or sell the stock for a specified price called striking price at a certain date in the future. So, the underlying asset for the stock future is the company’s stock. The stock futures derive its value from the price of the company’s stock.
Types of Stock Futures
There are two main stock futures available to investors namely; single stock futures (SSFs) and stock index futures.
Single stock futures (SSFs)
Future contracts that use the price of a single stock as the underlying asset are called single stock futures (SSFs). SSFs offer investors the opportunity to enhance the performance of their equity portfolios. With SSFs, investors can protect their investments against adverse price movements and cheaply diversify risk. In other words, investors can use single stock futures in place of stock to speculate or hedge against volatility risk of a particular stock. Some speculators prefer single stock futures because they are much easier to short than equities. Stock futures was initially banned in U.S in 1982 due to some regulatory issues. It was reintroduced when U.S passed the Commodity Futures Modernization Act (CFMA) in 2000. United States of America now has a fully electronic exchange in Chicago where all single stock futures are traded. The name of the exchange is OneChicago. OneChicago is bold to say that they are more than an exchange. It is more of a market place that can be described as a virtual community. That is why the exchange is fast becoming a toast for many investors that desire to trade single stock futures. OneChicago has SSFs on more than 1,800 U.S listed securities. These are accessible through its Delta 1 Trading Platform. Single stock futures are also available in UK, Europe, South Africa and Asian equity markets. Specifically, you can tarde SSFs in Eurex Exchange, ICE Exchange, Johannesburg Stock Exchange(JSE), London International Financial Futures Exchange(LIFFE). Investors should understand that they may be required to pay certain fee such as access fee, execution fee, carry fee, regulatory fee, connectivity fee and delivery fee. These fees are very small but can add up to be significant.
Stock index futures
Stock index futures otherwise known as equity index futures are future contracts that use the value of an index as an underlying asset. With stock equity index futures, you are trading on a bunch of equities without needing to trade the individual constituents. The index may track a particular sector or the market as a whole. An Index in the stock market is a calculated number based on the traded price and volume of a set of stocks. Examples of Index are S&P 500 Index and FTSE 100 Index. The price of stock index futures can be calculated in three ways namely price weighted index, capitalization weighted index and composite index. If price weighted index is used, the price of each component stock of the index will determine the value of the index. Therefore, the value of the index will be arrived at by adding unit price of each stock in the index and then divide the result by the total number of stocks. Therefore, stocks with higher price will carry more weight and will exert more influence on the index performance. A good example of price weighted index is Dow Jones Industrial Average. For capitalization weighted index, the value of the index is determined by the level of capitalization of each component stock in the index. That is, the price of each stock in the index is weighed based on its market capitalization. In this case, larger companies tend to have greater weighting. In order to calculate the value of the index, you will add up the market capitalization of each stock and then divide the figure by the total number of stocks. The sector with highly capitalized companies will have greater influence on the stock indices. A good example of capitalization weighted index is FTSE 100 Index. Composite index involved the use of standardized way in grouping the equities, indexes and other relevant factors in providing a statistical measure of a market or sector’s performance. A large number of factors are taken into consideration in determining the composite index. A good example of composite index is NASDAQ composite. You may want to know how dividends affect index prices. Any time dividends are paid on the component stocks of an index, the price of the intend tends to fall. However, this may not affect the investors in stock futures as all expected dividends must have been factored into the price of the contract.
What to know about Stock Futures
- Not all stocks have futures: I believe you are familiar with stock trading. If you want to buy a particular stock, you can place your order in as much the stock is not under trading suspension. You have different options to choose from. You may want to pick any company that is listed in the stock exchange or you may want to narrow down your pick to a particular type of stocks or stocks within a particular industry. Stock futures work in a similar way but the different here is that not all stocks have futures. Before you start spending hours researching in a particular stock, it is important that you first find out if the stock has a stock future. Some stock exchanges usually display the pre-market rates on the websites. You can get the latest data from stocks futures of major world indexes from Bloomberg. At least, this can give you a clue about the stock futures that are available on the stock exchange.
- You don’t buy stocks: Another peculiarity about stock futures is that you don’t take possession of any stocks as in the case of stock trading. If you buy stocks, the number of stocks will be transferred to you after clearing. You will be able to see it in your account. In the case of stock futures, you don’t buy stocks in actual sense as you will not find any stocks credited to your account. The only thing is that the money you pay to buy the stock futures will be removed from your trading account. And the balance in your trading account will keep fluctuating every day based on the value of the underlying stocks. In stock trading, the balance in your trading account does not change based on the value of the stocks you hold until you sell the stocks you hold or buy additional stocks.
- Futures have expiry dates. Stock futures are for specified dates. For example, a stock future may be issued for three or six months. When the futures expire you are contractually bound to complete the purchase or sale of the stock named in the futures contract. But you can buy or sell your futures before the expiry dates. In stock trading, you can decide to hold a particular stock as long as you desire. You are not under any obligation to sell at any particular time. You only sell based on your financial needs or financial goals.
- No shareholder’s right: Stock futures do not qualify you to be counted as one of the shareholders of the company. Therefore, you don’t enjoy shareholders’ rights such as voting rights. It does not matter when you buy the stock future whether before or after ex-dividend date. You are not entitled to receive any dividends.
- You make money when the price goes up or down. In stock trading, investors usually like to buy stocks when the price is low. If the prices of the stocks go up, they can sell in order to cash in their profits. But if the prices of the stocks fall, this will mean a loss if they sell the stocks. This means that investors can only make profits if the price of their stocks increases. For stock futures, you can make profits on either way. You don’t only make profit when the price goes up. You can equally make profits if the price of the stock falls. How? It depends on the position you take per time. If you anticipate that the price of an underlying stock will rise, you can take a long position by buying stock futures. On the contrary, if you anticipate that the price of a stock may likely fall, you can take short position in the stock futures.
- Margin: Stock futures allow you to trade with margin. You don’t need to pay the contract full amount. You will only need to pay for a percentage of the price of the contract. This can vary between 15% and 20% of the contract price. This is known as leverage. Leverage allows investors to take exposure in the market that is more than what is possible with their own resources. Investors only need to pay a margin which is just a fractional amount of the cash value of the stocks. This margin serves as a security. Even though you don’t pay for the total contract value, you will pay or receive the difference of contract values based on the price of the underlying stock and the striking price. However, this comes with a risk. If the investment made on the leverage falls below the margin deposited, the investor may be asked to deposit more money. Otherwise, your broker may sell the underlying stocks in the market. This is not the situation with stock trading. However, some stockbroking firms will allow you to trade with margin account. This works differently from the way it applies to stock futures. If you trade on margin, it means that your stockbroking firm is lending you money on which you expect to pay interest. The interest has nothing to do with whether you make profit or loss on your stocks.
- Futures are usually traded in lots: What does this means? Let me start with what you already understood. When investors trade in stocks, they can decide to buy or sell a particular number of stocks of a company ranging from single stock to several thousands of stocks. But in the case of stock futures, investors can only buy or sell contract at a pre-determined lot size. Lot size represents the number of the underlying stock that makes one contract. That is, the number of quantity in which you can trade in the derivative of particular stocks. The lot size depends on the underlying stock. For instance, a lot size can be 50, 100 or 200 units of the underlying stock. Supposing you are buying 10 lots of a future contract with a lot size of 200 shares, what this means is that you will get 2,000 units of the underlying stocks. Because the lot size is 200 shares, you will not be able to buy 1,500 units of shares of the underlying stock. The number of shares you can buy cannot be less than 200 shares and the total quantity must be divisible by 200.
- Account Management: Your investment value must not fall beyond a certain predetermined level called maintenance level. If it falls below the maintenance level, you may be asked by your broker to pay additional money in order for you to bring the value of your contract to the maintenance level. This process is called margin call.
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How to Trade Stock Futures
If you want to start trading stock futures, there are certain procedures you need to follow especially if you are keen at making profits from your investment. Below are the guides on some steps you can take:
- Select a brokerage firm: If you want to start trading stock futures, you need to open an account as a client with a broker. You need to search and select the broker that is right for you. There are many online brokerage firms but they all have their target clients. There are online brokerage firms that only accept institutional investors or individuals that have a lot of money to invest. You may not need to waste your time approaching them if you have just little amount of capital to invest. You need to select a firm that will accept the level of your capital. Also, you should not assume that the firm will allow margin trading. You need to make inquiry regarding this. Ensure that the firm offers stock futures in addition to normal stock trading. Another critical area you need to pay attention to is the issue of fees. What fees do you need to pay? Examples of fees you may be charged include annual fee, inactivity fee, trading platform fee and charges for research and data. If the fees are too high, it may erode whatever profits you make. Nevertheless, you need to balance this with quality service delivery which may include their availability when needed. Price doesn’t determine the best online broker. Some online brokerage firms’ websites may be very slow especially during peak trading hours. You may need to try this out to see if you will experience technical difficulty. Your preferred online broker should have good background in the trading of stocks and other financial instruments. Another decision you will need to make is whether to choose full-service broker or discount broker. A full service broker will be able to help you carry out research and advise you on the selection of stock futures that will help you reach your investment goals. But the fees of full service brokers may be higher. You may be asked to pay extra charges for broker-assisted trades. Nevertheless, if you have a good understanding of stock futures, discount broker may be suitable for you. In this case you will be responsible for your own stocks selection while the discount broker provides you the platform to carry out the trade. You may also choose a brokerage firm that has a mobile app you can use when on the go.
Read Also: How to Choose a Right Stock Broker
- Open a margin account: After you have chosen a broker, you should go ahead to fund your account. You will need to pay your initial deposit called margin to your broker before you can take position. Your broker may not accept the amount that is less than the required minimum initial deposit. At the same time, even though you have enough capital to invest, it is always better to start with little amount. This will help you reduce your risk. Stock futures involve a considerable high risk. The rule is that you should not invest the money you can’t afford to lose. It is risky to invest your emergency fund in stock futures. You should not even attempt it. Instead, you should save enough money in your emergency fund. A need may arise that you may need to meet urgent expenses such as payment of medical bills and repairs. Having enough money in your emergency fund will prevent you from terminating your investment at a wrong time which can result to a loss.
- Educate yourself: Education is the investment that will yield you best returns. Before you start investing in stock futures, I encourage you to invest in yourself first. With the various online resources available on the internet, information is very cheap now. You don’t need to pay through your nose before you can get educated in any topic of your interest. However, the source of the information you are getting is very important. Don’t just jump into stock options without acquiring good knowledge about how it works. It is preferable to start with stock trading. After you have mastered how to trade stocks very well, it will become easier for you to understand how stock futures work. It is also important that you have a trading strategy. You should understand that there is no strategy that works forever. What worked last year may no longer work today. Therefore, you need to keep learning. The whole world, including the markets keep changing in a very fast pace.
- Research stocks: Remember that not all stocks have futures. Therefore, if you want to invest in stock futures, you should focus on the equities that offer that feature. Have a good understanding of all factors that can affect the price of the underlying stocks. Such factors may include the general economic condition, company’s and industry performance, general price trend in the market, historical price trends, and government policies. You can always take advantage of the trading tools and research works made available on your broker website.
- Place stock futures order: Based on your research, you will know the right stock futures to trade and which position you need to take in the market. You can even use stock future as hedging against potential loss in your stocks portfolio. If you have an underlying stock, you can either buy or sell stock futures of the same shares to avoid making loss. If you anticipate a short term fall in the stock price, you can sell a future. The gains that you will make when you sell the stock futures will help you offset the loss caused by the fall in the price of the stock. On the other hand, if you anticipate a rise in the price of the underlying stock, you can benefit from the increase of the price of the stocks without necessarily selling your shares. You can achieve this by taking a long position in same underlying stocks. You can even make more profits by the reason of leverage made available in stock futures. Please, avoid using all the money in your account to place order. You should leave enough money in your account that can easily accommodate short term loss you may incur due to the fluctuation in the price of the underlying stock. This will prevent your broker from making a margin call on your account.
- Monitor the stocks: If you want to make money from stock futures, you need to constantly monitor the stocks and the market situation. The gains or losses you will make in stock futures contract are determined by the direction of the daily price movement. This is usually calculated on a daily basis. Unlike stock trading when you can only realise your gains or losses when the stocks is sold, the gains or losses on stock futures will be added or deducted from your account daily. Don’t forget that you can close out your futures contract before its expiration date.
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Advantages of Stock Futures
- Leverage: Stock futures allow investors to take large position with less capital investment. Unlike when you want to buy stocks, you need to pay the actual value of the stock in order to take possession. In case of stock futures, you only need to deposit a margin with the exchange. The margin serves as a security for the potential loss that may occur if the price of the underlying stock moves in the opposite direction to the position you have taken. If you want to buy stock, you will need to have the amount equivalent to the value of the stocks you want to buy. For example, if you want to buy a stock of 1,000 units selling at $50 each, you will need to pay $50,000. But if you want to buy a stock future at 10% margin, your cash outflow will just be $5,000 only.
- Liquidity: Future contracts have come to stay. You can be sure of the presence of a large numbers of buyers and sellers in the future markets. This makes it possible for investors to place their order very quickly. A large position taken by an investor may not be significant enough to affect the overall markets to the extent of impacting the price of the underlying stock adversely. Therefore, investors with future contracts that are approaching their maturity date may not have the price of their assets fluctuated drastically.
- Low costs: The transaction cost on future contract is very low especially if you don’t sign up for full service brokerage.
- Hedging and Diversification: Future contracts provide some levels of diversification and hedging for investors against the volatility of price in the stock market. If you hold stocks that you anticipate that its price may fall, you can take a short position to cover the possible loss you might suffer on the stocks.
- Faster returns: For speculators who are looking for ways of making quick returns on their investments, stock futures can be an option. The return is not only faster, it can also be better if they get it right.
Disadvantages of Stock Futures
- High risk: It is not a gainsaying that future contracts are very risky. Leverage can work either way. The same way stock futures can help you make high profits with little resources, at the same time, the rate of loss you can incur can be exceptionally high too. That is why it is advisable that you don’t invest the money you can’t afford to lose. It will amount to double tragedy to borrow money and then invest it in future contract. If you lose out of the contract, you will not only lose the margin you deposited, you will need to pay back the loan with interest.
- No shareholder’s rights: Stock futures do not give you right to vote. You are not entitled to dividends payment either.
- Margin call can result to more loss: If the price of the underlying stocks goes in the opposite direction of the position you take, the loss can quickly erode your margin account. If you don’t make additional deposit, the broker may terminate the contract abruptly.
- It requires close monitoring: Future contracts are for people who have good understanding of how the markets work. Furthermore, you will need to be monitoring the stocks on a regular basis. You need to be an active trader in order to make money from stock futures. It is not the type of investment you can make that you will go and sleep. Market volatility within a week can erode your margin. This become worse if you have multiple single stock futures.