Investing Basics: Futures

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On-screen text: Disclosure: Futures trading involves substantial risk and is not suitable for all investors. Certain requirements must be met to trade futures. Please read the Risk Disclosure Statement for Futures and Options before considering any futures transactions. Futures accounts are not protected by the SIPC.

Narrator: A futures contract is an agreement to buy or sell a specific amount of a commodity or financial instrument at a specific price on a specific date in the future.

To help you understand why businesses and individuals trade futures, let's examine how futures contracts can be used, the key components that make up a contract, and how much it costs to trade a futures contract.

Animation: Screen shows a price chart fluctuating.

Narrator: One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change.

Let's look at how this might work for businesses using the coffee industry as an example. If the price of coffee beans goes down, it's good news for coffee shops but bad news for coffee farmers. However, if the price of coffee beans goes up, the tables turn. With coffee bean futures, both coffee producers and coffee users are able to lock in prices ahead of time.

Now let's look at how this might work for individuals. Say you're looking to buy a new home in a year, and you're afraid interest rates might rise and increase your mortgage payment. You could offset a potential interest rate increase by trading interest rate futures such as the 30-year U.S. Treasury bond or 10-year Treasury note, depending on your time horizon.

On-screen text: Disclosure: Futures trading involves substantial risk and is not suitable for all investors, and you can experience a significant loss of funds, or you may lose more than the funds you invested.

Narrator: A second use of futures contracts is to allow traders to speculate on the price movement of commodities, currencies, stock market indexes, and other assets.

For example, consider the fluctuations in the price of a commodity like gold.

A futures trader can potentially profit by correctly guessing the direction that the price of gold will move. But if the futures trader guesses wrong, he can lose his entire investment and more.

Now that you know how a futures contract is used, let's look at five key components of a contract. These are also known as standard contract specifications.

Animation: Screen shows trading hours every day except Saturday.

Narrator: The first thing to look at is trading hours. Futures markets are open virtually 24 hours a day, six days a week; however, each product has its own unique trading hours.

Next, each contract specifies the tick size. Tick size is the minimum price increment a particular contract can fluctuate. Tick sizes and values vary from contract to contract.

A third standard component is contract size. Each commodity or financial instrument has a standardized contract size that doesn't change. For example, one contract of crude oil always represents 1,000 barrels. One contract of gold futures represents 100 troy ounces. And one contract of E-mini S&P 500 futures represents $50 times the price of the S&P 500^® Index.

Another component is contract value, which is also known as notional value. This is the current market value of the commodity represented in a futures contract. To calculate this, multiply the size of the contract by the current price. As you just learned, the E-mini S&P 500 futures contract is $50 times the price of the index. If the index is quoted at 2,250, the notional value of one e-mini contract would be $112,500.

Finally, there's delivery. Contracts are either financially settled or physically settled. Financially settled futures contracts expire directly into cash at expiration. This includes products like the E-mini S&P 500 index futures. Physically settled futures contracts expire directly into the physical commodity. This includes products like crude oil. For example, anyone long a contract in crude oil at expiration will receive 1,000 barrels of crude oil. However, don't be worried about 1,000 barrels showing up at your front door. Charles Schwab Futures and Forex LLC does NOT allow clients to take physical delivery—you are required to close the position before the delivery date, and if you don't, it will be closed for you.

Now, to understand how much it costs to trade a futures contract, let's look at an example.

On-screen text: Disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.

Narrator: Suppose a crude oil futures contract is trading at $50. At this price, 1,000 barrels of crude oil would cost $50,000.

But a trader doesn't actually have to come up with this amount.

With a futures contract, a trader could take a position in $50,000 worth of crude oil with just a small deposit.

This deposit is called the initial margin requirement, and it refers to the minimum amount of funds a trader needs to enter into a futures contract.

The initial margin requirement is set by the exchange and subject to change, but in our example…

On-screen text: Disclosure: Trading on margin increases your level of market risk. Your downside financial risk is not limited to the amount of equity in your account. Charles Schwab Futures and Forex LLC (CSFF) may liquidate any or all of your positions at any time if your account equity drops below required margin levels. CSFF may increase its "house" maintenance margin requirements at any time and is not required to provide you with advance notice. You are not entitled to an extension of time on any type of margin call.

Narrator: …we'll say that to purchase one crude oil futures contract, the trader had to put up $3,000 for margin to control nearly $50,000 in oil.

Animation: A small stack of money is on the left side of a balance beam to represent the $3,000 initial margin requirement, which holds up the $50,000 futures crude oil contract higher on the right.

Narrator: As you can see, futures can allow you to leverage a relatively small amount of capital to take a position in a larger underlying asset.

Because of this leverage, small changes in the price of the underlying asset have a much larger impact on the futures contract. Keep in mind that although leverage allows for strong potential returns, it can also result in significant losses. And if losses are substantial, you'll have to add more money to cover losses.

Now you know how futures contracts can be used, what the contract specifications are, and how much a futures contract costs.

If you're interested in learning more about futures, it's important that you expand your investing education before you make investments. But we're here to help.

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