What is a future?
A futures contract, often abbreviated as ‘future’, represents the purchase or sale of something with a future settlement date. When you buy a future, you own the item with all the opportunity for gain and risk of loss. But the item is not yet delivered, and beyond the transaction cost of the contract, cash does not change hands.
Futures have three key attributes: (1) the underlying thing, such as a commodity or currency; (2) the price at which this thing is bought or sold, called the settlement price; and (3) the date on which the transaction will settle, called the delivery or final settlement date.
An important issue with futures is the ability to deliver or take delivery of the item contracted. Some financial responsibility is demanded. Here that means there is a ‘margin’ requirement – an amount of money that must be deposited and/or maintained in an account while the contract is in force. For example, if the margin requirement for corn is 10%, you could buy $100,000 worth of corn and deposit only $10,000. By delivery date you would have to sell the contract or come up with another $90,000 (and be ready to receive a whole bunch of corn).
Futures are used for a number of purposes. Farmers, miners, and others who extract or produce raw goods can lock in levels of income. Food manufacturers and industries of all kinds can lock in levels of costs. Futures can be a useful instrument for those who physically work with the items being traded. For people not involved with production or processing the underlying items, trading in futures is pure speculation with possibly disastrous consequences.
Why you should avoid futures
Massive loss potential
Given generous margin requirements that allow you to establish positions many times greater than your available capital, there is tremendous opportunity for massive loss. Taking the example above, if the price of corn falls 20% before the contract expires, this $100,000 future generates a loss of $20,000 to the buyer. Think of this: you deposit $10,000 for margin; you lose it all; and then you have to pay another $10,000 to cover the rest of the loss. After a 10% move in the underlying commodity, you lost 200% of the cash you invested.
Zero sum game
While all participants in the stock and bond markets can profit in the long run as economic growth leads to rising stock prices and payment of interest and dividends, futures contracts render no net profits. One party will make as much money as the other party loses. Futures are not investments; they are coin tosses.
Information disadvantage
Farmers and food processors, miners and manufacturers, investment bankers and financial engineers all study their markets intensely. Facing extreme potential for loss, futures buyers and sellers regularly employ expert meteorologists, geologists and math PhDs. A zero-sum game in which you are at a huge disadvantage with massive loss potential is not one you want to be playing.
What you should do instead
If your interest in futures is high returns, this is not the right market. Huge risk would be added to your portfolio. In all likelihood returns would drop – perhaps to the point of financial ruin. Instead, reassess your risk tolerance. If you can handle a higher level of potential volatility, appropriately increase your exposure to stocks, reducing cash and bonds at the same time.
If your interest in futures stems from recent articles or research, know that experts who trade in the pertinent field read, perhaps even wrote, the same pieces. You are always at a disadvantage. Knowledgeable professionals already executed trades to move the markets before you finished reading. Facts and strong probabilities suggest you’ll make more money in stocks and bonds than futures. Stick with the regular markets.
* Data sources: The Vanguard Group, Inc., Morningstar, Inc.