The futures market is one of the riskiest markets in the world and not many people know how it works. In fact, it is rather quite simple. There are many different types of futures contracts from commodities to stock, but they all fundamentally function in the same manner. However, this passage focuses on stock futures.
The futures market works similarly to the stock market, as you need a buyer, a seller and an entity to facilitate the trade. What happens is that two participants enter into a contract to either long (buy) or short (sell) a stock for a specific price and quantity on a predetermined date in the future. Unlike other investment contracts, you do not have to hold futures until their date of maturity, you can buy and sell them on the futures market freely.
Unlike buying a share of a stock through the stock exchange, you never actually own the stock that you are agreeing to buy or sell on the futures contract. This means you won’t receive dividends and can’t vote at shareholder meetings. When the contract reaches its expiration date, the person who is holding the contract for the long position buys the stock and the person who is holding the short position sells the stock.
When getting a futures contract, if you are optimistic about a specific stock, you would want to go long. If you are pessimistic about a certain stock, you simply would want to go short. Another advantage of trading futures contracts is that they are bought on margin. This means you will only usually pay 10-20% of the contracts margin. Brokers and brokerages leverage your money in order for this to happen.
This is also why futures are classified as a high-risk investment. For example, you go long on 50 shares of a $100 stock. You have 15% margin so you only have to pay $750 for the contract that is worth $5,000. When the contract reaches its date of expiration, the stock ends up being worth $80 a share. Not only do you lose your entire initial investment of $750, but you also have to pay another $250. But, what if you were shorting the $100 stock instead? You would have made $1,000 of profit on a $750 initial investment. This is a return of 133% over a period of a few months.
There are measures in place to prevent the first part of the example from happening. Many brokers and brokerages will perform a margin call in the event that the stock price falls below a specific value known as the maintenance level. When you get a margin call, you have to pay your broker or brokerage additional capital to keep the trade active or you will have to close the trade at a definite loss.