Futures contracts were originally designed as hedging tools or “insurances” for the trading of commodities like wheat. As the production of wheat takes a long time and prices may change for the better or worse during that year those wheat takes to grow to maturity, the buyer of the wheat can go into an agreement with the farmer to buy their wheat upon harvest at a price agreed upon right now. Such an agreement made sure that the buyer will always be able to buy those wheat exactly at the price he wanted to and the farmer also had assurance that he will be able to sell his wheat at that price even if the price tanks during harvest. That is the original purpose of futures contracts.
However, with the creation of modern futures markets where similar futures contracts can be freely traded amongst futures traders as well as the creation of futures contracts on less traditional assets such as stocks and indexes, futures trading became a speculation tool as well.
Yes, futures on stocks is a pretty recent innovation that has yet to be as widely popular as stock options. These futures on stocks are known as Single Stock Futures. Single stock futures are futures contracts with stocks as their underlying asset. This means that when you take delivery on the futures contract as a long, you receive the stocks that are covered by the futures contracts.
The beauty of Single Stock Futures as a speculation tool can be summed up in a single word “Leverage”. Leverage means doing more with less and in this case, it means controlling the profit on more stocks with less money, which in turn means making more money with lesser money.
Single Stock Futures allows you to control the underlying stock using only 25% of the cash that would be paid for the stock itself! For instance, if AAPL is trading at $200 and 100 shares costs $20,000, you could control that same 100 shares of AAPL using only $5000! Good news is, that $5000 that you “paid” in order to buy AAPL’s single stock futures remains your money and would be used for the deduction of losses in the position or returned to you along with profits if the position is closed profitably! This is known as an Initial Margin.
Now, assuming you bought the above futures contracts and AAPL went up $10 the very same day, your account would be credited with $1,000 ($10 x 100) the very same day! This means that you made $1000 using $5000 in just one day through futures trading instead of making that same $1000 using $20,000 by buying the stock itself. That’s leverage.
Now, assuming you bought the above futures contracts and AAPL went down $10 the very same day. The $1000 in loss would be deducted from that $5000 you initially paid in order to put on the position. See how that $5000 is really still your money?
Now, what if the stock fell by a mile in a day?
That takes us to the risk of futures trading, margin calls. If AAPL fell enough to bring your $5000 initial balance down below a limit set by the exchange known as the “maintenance margin”, you would receive a notice by the broker to top up your account back up to that initial $5000. If you don’t have the cash to do that, your position would be closed by the broker immediately. Yes, the stock can go up in your favor and it can also go down. In actual fact, you are not losing more money than trading the stock itself by trading its futures. You will lose the exact same amount of money as if you were holding the same amount of underlying stock itself. This means that even though you paid little to put on the position, you must be prepared with more cash than needed in order to survive those temporary pullbacks that inevitably happen in the stock market.
The problem with most beginner futures traders is that they are prepared only for winning, not for losing and usually have little or no cash left on the sidelines to support temporary losses.
In conclusion, trading single stock futures gives you leverage and the ability to make more with less but you should also be prepared with more cash than needed in order to meet temporary losses. Remember, leverage cuts both ways. Consult your broker to see if they offer single stock futures trading and definitely get a mentor to guide you through your initial trades.