Everyone is familiar with equity securities. These are the stock shares that trade on exchanges like the New York stock exchange, with traders yelling and hustling around the floor to buy low and sell high. Equity securities, more colloquially known as stock, represents ownership in a corporation. When this changes hands, the new owner instantly takes over ownership interest from the seller, and takes ownership at the execution price.
Future contracts are different from stocks, but the underlying security of a futures contract may be equity securities. Futures contracts cover a wider universe of underlying securities than just stocks though, futures contracts may be made on commodities like gold or oil, interest rates, or even the weather!
A futures contract is a contract between two parties, in which the parties agree to sell and buy a set quantity and quality of some asset at an agreed upon later date, for an agreed upon price. Futures prices also trade on exchanges just like equities. Today, just like equities, most futures contract trading now takes place over electronic systems. Both the Chicago Board of Mercantile Exchange and the New York Stock Exchange own futures trading platforms, and very little open outcry trading takes place worldwide anymore.
Futures contracts fluctuate in price just like shares of a stock. The reasons for changes in price are the same principals of stock trading, as market conditions change, the future expected value of an underlying security changes, and the price of contracts adjusts accordingly.
For instance oil future contracts are very popular. A 30 day contract may have a price of $100 per barrel, meaning the buyer is locking in his purchase price in 30 days at $100 per barrel. If the price of oil in 30 days is actually $110, the buyer still only paid $100. He now owns an asset worth more at current market value than the price he paid. As the price of oil is rising, obviously the contract will not continue to trade at the same value, and the owner can either choose to hold the contract until expiration, or sell for a profit on the secondary market.
A key fundamental difference between an equity security and a futures contract is the way in which the market determines prices. An equity security is always priced on what the market believes it is worth today. A futures contract will always be priced based on what the market expects it to be worth in the future, at expiration. If an asset is spot trading at some price, while rare, it is possible that the market will expect a lower price in the future, and the futures contract price will imply a lower future expected value.
Equity securities are much more liquid in large quantities, and very efficiently priced with very low spreads. Futures contracts are not necessarily as liquid, though popularly traded futures contracts are about equally as liquid from a retail trader’s perspective. Spreads may be larger, however, and price may be more volatile.
For many people the benefit of futures contracts is that they can trade assets in a wider spectrum than equities, and for those who are shrewd, there may be more potential to profit from inefficient pricing.