Futures 101

But should you trade them?

These instruments are quite complex and still evolving. So let's start with the basics. Futures are defined as contracts between two parties today to deliver (or receive) a set quantity of a commodity or product at a prespecified date in the future for — here's the kicker — a price that is set in the present. They are the cousin to options.

Futures are traded on everything from livestock to financial instruments such as currencies and government bonds. Futures trading allows for both hedging against wild price swings — whether up or down — and the ability for speculators to bet on a future outcome (say, for instance a soybean glut sending prices lower or heightened crude oil demand outstripping supply and moving prices up).

The logic is plain. Suppose you own a bread company that's highly exposed to price fluctuations in your biggest ingredient — wheat. By buying wheat futures, you can partake of some of the upside should prices spike and force your company to have to pony up more for wheat and its byproducts (tampering the price hit you have to sustain).

Or suppose you're a money manager with clients fully invested in stocks, and you want a degree of broad, one-size-fits-all downside protection. Going short S&P 500 futures or perhaps long crude oil futures — which lately have been moving inversely proportional to the equity indexes — could achieve that goal.

Effectively large-scale options, futures allow for this critical kind of hedging — a highly customizable form of insurance. They reside in the realm of derivatives — broadly defined as financial instruments whose value is "derived" according to a movement in an underlying commodity, index or indicator. Futures are financial products that are once or twice removed from an actual product, like a barrel of oil. Futures contracts, moreover, expire like options at the third Friday of the month.

Futures contracts can call for either the outright physical delivery of a commodity or, more commonly, cash settlement as a placeholder for that product. After all, very few futures traders actually have the desire or capacity to take delivery of thousands of bushels of wheat, pounds of sugar, or millions in stacks of Treasury bills.

Leverage
Futures trading is a highly leveraged species. Specifically, a relatively small amount of money, say a margin deposit of just $1,000, can allow you to buy or sell a contract representing $25,000 worth of soybeans. $10,000 can buy you a futures contract that represents listed stocks worth $260,000. The smaller that initial margin as a proportion of the underlying value of the futures contract, the greater the leverage.

That can cut both ways, of course.

If you bet correctly on the direction of a commodity price, that high leverage can produce outsize profits compared to your initial outlay; if prices move in the opposite direction, you're looking at especially painful losses.

Consider a hypothetical trade in a June S&P 500 stock index futures contract. Assume the June index is trading at 1000, and that your initial margin requirement is $10,000. The futures contract is valued at $250 times the index, making each one-point move in the index result in a $250 gain or loss.

So if the index moved up from 1000 to 1040, that 40-point gain would double (40*$250) your $10,000 margin deposit. On the flip side, a 40-point loss from 1000 to 960 would wipe out your initial bet. In other words, a 4% move in the index begets a 100% gain or loss in your investment. High stakes...

Futures trading accordingly requires both an iron gut and significant liquidity.