Investing in the stock market involves a variety of financial instruments, each with their own unique benefits and risks.
Among these, stock futures options and derivatives stand out as a popular choice for traders who are looking to hedge against unpredictable market movements or those who wish to benefit by speculating on future price changes.
But what are stock futures, and how do they fit into the broader world of options and derivatives? Let’s find out.
What Are Stock Futures?
A stock future is a type of derivative contract which requires that the buyer purchase, and the seller sell, a specific quantity of a stock at a predetermined price on an already fixed date.
This is rather different from options, where the buyer has no obligation to execute the contract. In stock futures, both parties need to fulfil the terms of the agreement.
Stock futures are part of a broader category known as options and derivatives that acquire their value from an underlying asset, such as stocks, bonds, commodities, or indices. In the case of stock futures, the underlying asset is a specific stock or a stock index.
The Basic Workings of Stock Futures
Understanding what stock futures are also involves knowing how they function in the market. When you buy a stock future, you agree to purchase a stock at a set price on a specific date, regardless of the stock’s market price at that time. On the other hand, if you sell a stock future, you agree to deliver the stock at the agreed-upon price on the future date.
For example, if you believe that the price of a particular stock will rise in the future, you might buy a stock future at the current price. If the stock’s price increases by the contract’s expiration date, you can either sell the future at a profit or take delivery of the stock at the lower agreed price.
On the other hand, if you anticipate a decline in the stock’s price, you might sell a stock future. If the price drops, you can buy the stock at the lower market price and sell it at the higher contract price, thus making a profit.
Benefits of Trading Stock Futures
1. Leverage
Futures contracts typically require only a small margin or initial deposit, allowing you to control a larger position with a smaller amount of capital.
This leverage can amplify your gains if the market moves in your favour, though it also increases the risk of losses if the market goes against you.
2. Hedging
Stock futures are commonly used as a hedging tool by investors who want to protect their portfolios from adverse market movements.
For example, if you own a large position in a particular stock and are concerned about a potential decline in its price, you can sell stock futures on that stock to offset your losses.
If the stock’s price falls, the gains from the futures contract can help mitigate the losses in your portfolio.
3. Flexibility
Whether you’re looking to profit from short-term price movements or hedge against long-term risks, futures contracts can be tailored to suit your specific needs. This flexibility makes them a versatile tool in the world of options and derivatives.
4. Market Efficiency
Futures markets are generally more liquid and efficient than the underlying, what are stock futures, especially for popular stocks and indices. This means that you can enter and exit positions quickly and at competitive prices, making it easier to manage your investments.
5. Speculation
If you’re willing to take on higher risk, stock futures provide an opportunity to speculate on the future direction of stock prices. By predicting whether a stock’s price will rise or fall, you can take positions in futures contracts to potentially profit from these movements.
Conclusion
Stock futures offer numerous benefits, but it’s also necessary to be aware of the risks involved. Leverage makes futures attractive, but unlike options where you don’t have the obligation, futures require you to fulfil the agreement.
This can potentially result in substantial financial commitments. Therefore, understanding what stock futures are and how they function can help you make informed trading decisions.
