What is stock futures in investing?

Stock Futures are financial contracts that have individual stock as the underlying assets. It is formed based on a contract agreement to buy or sell a certain amount of underlying equity share for a future date, at an agreed price between the buyer and seller. There are certain features that form the market standard for futures such as expiry date, the unit of price quotation, method of settlement, and market lot.

Stock Futures Explained

The concept of stock futures is very easy to understand. Assuming you own a fabric manufacturing company and you need cotton to produce some of your fabrics. The way financial markets work, the price of commodity changes every business day. As a business person, you can’t possibly keep changing your prices every day and you would want to buy cotton at the least lowest price so you can run your business at a gain and make a profit. The changing price of the market may hinder you from achieving this goal, therefore, the best way to go about it is to enter a futures contract with your seller by agreeing on a futures date and a certain price.

Stock futures operate in a similar way; the major difference is the underlying asset or commodity. Here, a buyer and a seller enter into an agreement to buy or sell a specific amount of stock at a future date for a certain amount.

Stock futures offer investors a variety of opportunities; for example, a stock futures investor can opt for long-term investing using stock futures. They also offer investors relatively high leverage to take one large position with less capital.

Generally, futures tend to either seem overpriced or underpriced compared to the spot and may provide investors with arbitrage opportunities. Arbitrage opportunities are mostly associated with single stock futures, this opportunity arises between stock futures and the underlying cash market. Single stock futures can also be used as an effective management tool if used well.

Stock Futures Pricing

Theoretically, the price of a futures contract is the sum total of the spot price and cost of carry. In reality, however, the actual price of a futures contract is dependent on the demand and supply of the underlying asset. Cost of carry is the net cost of holding a position.

Formula

Futures Price = Spot Price + Cost of Carry

Stock Futures Vs Stock Options

In stock futures, the buyer and seller both have the right and obligation to buy or sell the underlying share. Whereas in stock options, the option buyer only has the right to buy or sell the underlying share with no obligation whatsoever.

When it comes to pricing, the price of stock futures is majorly influenced by the prices of the underlying stock, while in stock options there are other determiners that influence the prices. These determiners include volatility of the underlying stock, with the prices of the underlying stock.