What are Futures?

The purpose of this article is not to tell you whether or not you should invest in some futures contracts, that is a personal decision that you must make on your own, perhaps with the advice of a broker. The purpose is only to give you a little better idea of what exactly a futures contract is so that you can make your own well-informed investment decision.

A futures contract is an agreement to sell or buy a particular (specified) asset in a designated future month at a price agreed upon by the buyer and seller. The difference between a futures contract and an options contract is that the latter gives the right to buy or sell whereas a futures contract is the promise to actually make a transaction. Note that the date of the transaction on a futures contract is specified by month only since all futures transactions occur on the Saturday immediately following the third Friday of each month.

There are two different major types of futures contracts; a contract may either call for delivery of a particular asset or it might call for a cash settlement. In the former type, delivery of goods is rarely completed; instead, an offsetting futures or options contract is bought prior to the completion date as a method of realizing profits.

Price Discovery for Futures Contracts

Keep in mind that the main driving factor in futures prices, as with prices of most other investments, is the sum of the expectations of all buyers and sellers of the performance of the asset backing the future in question. The major difference between futures and other investments is that futures are always concerned, obviously, with the future value of an asset and not its current value alone. As with most things, the price of a futures contract is dictated by the rules of supply and demand.

Margins

If you are new to futures trading you should be aware that the term margin has a different meaning than with common stocks. Normally the term margin refers to the cash down payment paid to a broker to purchase stocks, but it has a completely different meaning in the context of futures. In futures, the term margin refers to a 'deposit of good faith' to your brokerage firm that can be used to cover any losses you may incur in futures trading. It is refunded when you liquidate your contract. A minimum margin requirement for a particular futures contract are set by the exchange upon which the contract is being traded. In general they are five to ten percent of the value of the futures contract in question. Note that a brokerage may charge more than the minimum margin. You should also be aware that in addition to the initial margin required by the brokerage, if your account drops to below a certain level the brokerage may charge what are called maintenance margins to keep your account active. Be sure to understand clearly your brokerage firm's margin agreement before trading in futures.

For those who can truly understand and appreciate the potential offered by futures contracts - and can afford the potential risks - futures trading can offer a means to diversify your portfolio and even increase returns on investment by providing access to trading techniques unavailable in regular stock trading.

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