For investors looking to become involved in the stock market, there are many things to consider. Trading offers the opportunity to buy stocks in a variety of different ways, some of which you may not be aware of. For example, in addition to buying stocks today, you can also invest in stock market futures.
What are stock market futures? How do they work? And, are they a smart idea for investors to consider?
Also known as ‘futures,’ these types of stocks refer to a contract that is made between a buyer and a seller that is based on a future agreement for a specific stock. The buyer is agreeing to enter into a financial contract that holds them accountable to pay for a stock at a predetermined date, for a predetermined price.
As you can imagine, agreeing to buy something in the future for a predetermined price comes with its risks. Futures are not for the investor who is looking for a safe, reliable investing option that they can easily get rid of or make a quick buck from. However, there are certainly advantages to stock market futures including the potential to make a significant profit, for those willing to take the risk.
To learn more, let’s explore more about stock market futures, including how they work. Then, I’ll outline the advantages and disadvantages for these types of stock agreements.
What are Stock Market Futures?
Stock market futures are essentially a form of a financial agreement that details the specifics of a stock’s price at a future date, which has been agreed upon between a buyer and a seller. They are not limited to a specific type of stock, or to a particular type of market sector. They can be initiated for many different types of companies, including tech stocks, various startups, and others.
Futures outline the particular details that the buyer and seller have agreed to. This will include the quantity of stock the buyer has agreed to purchase as well as many other details. It’s important to note that most stock market futures are not held to their expiration dates. In fact, it’s fairly common for stock market futures contracts to be sold on the futures market.
The futures market allows traders to resell their stock market futures contract to other buyers, based on the relative value of their agreement and the specific stock involved. Buyers and sellers will base this estimation on the performance of the stock on the S&P 500 or other stock market index.
As you can see, there are many intricacies to stock market futures. They are not a black and white deal that is easily understood. There are many factors to understand when investors choose to buy or sell futures, and it’s important to understand the advantages and disadvantages of these agreements to avoid losing money.
How Do Stock Market Futures Work?
Ultimately, an investor needs to understand that when they’re buying stock market futures, they are not purchasing a tangible stock certificate that they own right then and there. They’re also not earning dividends on the stock, or able to attend stockholders’ meetings for that particular stock. What you’re buying is an agreement that outlines a future stock purchase.
Stock market futures are considered over the course of a few months’ time period. Prior to purchasing a futures contract, traders should have an understanding whether they will want to buy and resell the stock relatively quickly (within 3 months), or hold on to the futures contract longer than 3 months. If a buyer is afraid the stock will not continue to gain value, they will buy out their contract as planned on the agreed upon date and then try to resell the stock once they own it.
Ultimately, there is risk for both the buyer and seller when dealing with the futures market. Each party is taking a gamble that the price of the stock will either rise or fall in their favor, and of course, no one knows exactly how the stock will perform.
Advantages and Disadvantages of Stock Market Futures
The biggest advantage to entering the stock market futures market is the potential to make a significant profit. This applies to both the buyer and the seller. Let’s look at two specific examples that demonstrate this logic.
Consider a buyer who agrees to purchase a stock for $10 on the stock market futures market. Over the course of their 3-month contract, the price of the stock increases $10. That means the buyer can honor their contract and resell the stock at $10 more than what they originally paid for it. It also means the seller took a hit on what they could have sold the stock for if they hadn’t entered the futures agreement.
In contrast, let’s consider a farmer who sells corn. The farmer never knows how prices within the food industry will fluctuate as it’s based on an influx of product, possible weather conditions, and many other factors. The spot price of corn could fall drastically between the time they harvest their crop and take it to market again the next season. Therefore, entering into a futures contract means they’re able to lock in a specific price for their crop, several months in advance which may protect them financially.
In every futures deal, the buyer and seller are taking a risk of losing or gaining a profit. The best way a trader can protect themselves in futures deals is by thoroughly researching the stock and clearly understanding the risks involved. Stockbrokers are legally required to give you information outlining the risks of futures trading when you invest.
What to Consider When Investing in Stock Market Futures
Whether or not it’s a good idea for you to invest in stock market futures comes down to the risk you’re willing to take in your stock investments. Are you looking for a safe, reliable stock option that you can count on to perform a certain way and offers little risk? If so, the futures market may not be the best option for you.
In contrast, if you’re open to the idea that you’re able to predict stock trends and potentially make a profit if your stocks perform how you predicted, these contracts are a good option for your financial portfolio.
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