One concept that often baffles new investors is that of stock futures. We will explain how things like interest rate(s), fixed price, tick size, contract size, current market value, and forward price(s) impact the value of a stock future as well as how these are traded in the market.
Stock futures, like short selling, are a kind of market indicator of where traders think a security will head within a given timeframe.
This can be used to predict performance down the road as well as indicate to other traders Wall Street’s confidence in a company’s current direction. Whereas short selling is a bet that the company will decline in value, and obligates a trader to either cover their position if the stock goes up instead, stock futures are predetermined contracts that set pricing ahead of time.
A short seller can continue to double-down on their investment for good or ill, a stock future is executed upon the predetermined date regardless of gains or losses accrued. Both are advanced strategies that should only be undertaken by experienced traders though it is often the former that gets more attention in the media.
This is because short selling comes with the inherent risk of infinite losses; or, in other words, a trader can bet that a stock will go down only for its value to continue to climb until it reaches the total value of all monetary units on the market (the theoretically infinite price ceiling).
As the price of a stock climbs, short sellers have to post money to cover the difference between their position and the new value. Only when the value collapses do they reap massive sums of money.
Stock futures are bound by the contract period and forward price with gains and losses executing upon its completion.
When used with regard to commodities, futures help traders or companies secure necessary components at a certain price. This helps them hedge against the price rising in the near future.
As applied to stocks, futures allow a trader to hedge against sudden price movements and, depending on the contract size, traders are sometimes not obligated to place the full amount at risk.
The name should tell you a lot of the story but we’ll go into some detail since there are differences between options in the United States and in the European financial system.
For the United States, options are the right to buy or sell a certain security within trading hours on a specific date sometimes at a predetermined price known as the forward price; however, options do not obligate the trader to purchase them.
In the European system, the buyer only has the right to execute an options contract upon its expiration, not before, yet also has the right to refuse without obligation as in the US system.
Profit and loss in a stock futures contract are simple in their most basic mechanical functions. If a trader purchases a stock future and the current market value of the stock rises, a profit is made; if it falls, a loss is recorded.
Stock futures are a quite powerful strategy because it allows for margin investing or, in other words, traders can risk much more than they currently have in their portfolio. The major upside is mirrored here by the downside: Margin allows you to amplify gains, but it similarly magnifies losses.
Other factors such as interest rates and the contract size can also come into play. Now we have to explain the concept of tick size as it relates to stock futures. A rather complicated topic in reality, at its simplest form tick size refers to the smallest quantifiable dollar value in which a security can fluctuate.
These are essential to figuring out how much a trade is going to cost as well as how much it could potentially make or lose.
Tick size varies depending on the security in question but one common example is tick size in stock trading where a security’s price can move up or down in values of .01. The tick size increases or decreases by this increment as the value of the security rises or falls.
In the example of a stock share, if it is valued at $1.00 then it can move up or down in values such as $1.01 or $0.59 and so on along the increment determined by the tick size.
Aside from the benefits of trading on margin, why would traders pursue a stock futures
After all, it seems quite similar to short selling but without the almost limitless upside that can entail if your bet goes right.
Stock futures provide investors with a hedge against losses and volatile market activity.
How is this accomplished?
Again, we’re talking about advanced and often arcane strategies that can be employed with varying complexity.
Futures hedging is a strategy whereby an investor can both bet on the rise and fall of a security within a certain amount to stabilize their returns and offer a kind of predictability to them. As we mentioned above with commodity prices, futures hedging doesn’t just apply to securities: It can also be employed by companies or even everyday people.
For example, if you know that you use one gallon of milk every three days and that one gallon of milk is currently on sale, you could hedge against the future rise of the price of milk when the sale is over by purchasing enough milk for this week and next week.
Another example using something we all know and love: Smartphones.
A company that purchases semiconductor chips in bulk at today’s price because they anticipate scarcity and higher prices in the future is engaging in futures hedging. Like so many securities, stock futures are a bet in the rise or fall of an investment though they are distinguished from others with their fixed amounts and limited timeframes.
A powerful hedge against losses and market volatility, futures hedging is a strategy that can be employed by a securities trader, industrial company, or even your everyday consumer.