What Are Futures in Investing?

Estimated read time: 4 minutes

If you're new to the world of investing, you may have heard someone talking about futures. Whether you looked at them quizzically or nodded knowingly to make them think you weren't an investing newbie, you won't have to be in the dark much longer.

This article will give you the 411 on everything you'll need to know about futures. Pretty soon, you won't have to fake that knowing look when someone mentions it. You'll be the one leading the conversation.

Futures: A Primer

To fully understand what futures are, you need a little background lesson in commodities. Commodity exchanges got their start with the most essential of all human needs — food and beverages.

These commodities have continued to be important throughout the world because they bring in billions of dollars. Simple products like soybeans, beef, corn, and sugar are important cornerstones of the commodities market.

The commodities market has expanded to include other highly-profitable products that people can't live without in modern society. They include things like energy products, such as gasoline, oil, and electricity, as well as industrial metals and other materials vital to our everyday life.

Commodity exchanges are a way to allow manufacturers, consumers of commodities, and speculators to mitigate their risks. What does this have to do with futures? Everything, because futures markets are the vehicle used to sell those commodities, but commodities aren't the only part of futures trading — stocks, bonds, ETFs, and even bitcoin can be part of futures trading.

What Are Futures?

When you invest in futures, you're opting into an agreement to purchase or sell a product at a later date. But here's the kick — the price and terms are decided beforehand, when you enter into the contractual obligation. Here's why that can be beneficial to those buying futures: If the price goes up after you enter the contract, it doesn't matter. You don't have to pay the extra amount to get your commodity down the road. You'll only pay the agreed upon amount in your contractual obligation.

For instance, one type of futures contract that many municipalities participate in is fuel hedging. A city will agree on a particular price to lock in their fuel deliveries for a certain number of years. With something as volatile in price as fuel, those time frames tend to be fairly short — often contracts are for two or three years at a stretch.

It can be a risky move, but some cities, since they use a fair amount of gas for their machinery and city workers' vehicles, try to lock in rates in case gas prices would go up.

That can be useful not just as a cost-saving measure but as a way to create a set budget. That can save boards and councils from having to do budget amendments in the middle or toward the end of their fiscal years.

But you don't have to take physical possession of a product to get in on the futures market. You can be an investor or speculator, too — that's where the average investor can join in.

There are upsides and downsides to investing in futures. The pros are that you can get some inflation protection and diversify your portfolio. The biggest con is that commodities are highly volatile — they make stocks look stable.

How To Buy Futures

If you're intrigued by futures, the next step might be figuring out how to buy them. Well, if you're not prepared to enlist the help of a professional or pay more attention to the market than usual, perhaps you shouldn't. They are much more complex than many other investments you could consider.

Still, if you have a good nest egg saved up and you want to give futures a try, there are some things you should know first.

First off, be prepared to cough up some cash if you seriously want to invest in futures. You should plan on making what would constitute a major investment for most people. Plan on thousands of dollars for an investment.

Second, brace yourself. Remember how we called futures highly volatile? That can be great or it can be disastrous. If it comes out in your favor, you can make a good deal of money, but if things go south, you could lose your whole investment, potentially.

For that reason, if you're going to invest in futures, you should aim to keep that portion of your portfolio from 5 to 15 percent of your total investments. You shouldn't risk going much higher than 15 percent in futures because of how volatile they can be. Many investors, even more aggressive ones, wouldn't be comfortable losing more than 15 percent of their portfolio.

If you aren't sure about your risk tolerance, consult digital resources. There are some great risk tolerance quizzes online that will help you determine how you'll deal with market volatility.

And because investing in futures can be so time intensive if you're paying attention like you should, it might be pointless to put that much time into something that comprises less than 5 percent of your portfolio.

If you want to forge ahead, consult with a broker. Be prepared to answer questions about your net worth, salary, risk, and other investments you have.

Futures Vs. Options

Options is another term you might hear when people are talking about futures, but there's an important difference you should understand between the terms.

With futures, the buying or selling must happen on the date mentioned in the contractual obligation. But an option doesn't require that the transaction actually goes through. It just gives the buyer the right to make it happen. But there isn't an obligation to do so, such as there would be with futures.

Using Your New Knowledge

Just because you now understand futures doesn't mean that type of investment will make sense for your portfolio. Figure out whether futures investing is something you can afford to do, both financially and emotionally, because of the volatility involved. You might find yourself more drawn to other types of investments that require a lower risk, financially.

Even if it doesn't make sense for you right now, it's something you can consider at a later date. At the very least, you've now expanded your investing knowledge, and that's always a good thing.