What Are Stock Futures and How Do They Work?

Stock futures are best described by taking the term quite literally -- binding contracts to buy or sell a particular stock at a predetermined price and on a set date. They guarantee a price and a sale and can offer a way to generate profit if used to correctly speculate on the direction of the market.

How do stock futures work?

Let's use an example, shall we? Buying a stock future means that you lock in an agreed price on a stock and an agreed date that you'll purchase that stock.

So let's say you buy stock futures in Tesla (NASDAQ: TSLA). You decide that you want to purchase 100 shares of Tesla stock and the price is $1,000 per share. You also decide that you want to purchase these stocks in exactly three months' time. You can enter into a Tesla futures contract which locks in both that price and that date.

Your futures contract has a price of $100,000 when you enter it. But if the price of Tesla stock goes up to $1050 before the three months ends, you've now made a profit of $5,000 on the contract. This can be used in many ways.

Why do people buy stock futures?

One of the main reasons people do this is to protect themselves against market volatility. By guaranteeing the future price, investors can "hedge their bets" against unfavorable price movements. 

People also use stock futures to generate profit by speculating on the direction of the market. If an investor believes the price of a stock is going to rise significantly, they can use stock futures to guarantee a lower price. In the above example using Tesla, the owner of the futures contract could sell the contract before the three months had expired to collect the profit made on the stock.

One of the biggest attractions to buying stock futures is the fact that often you don't have to pay the full amount upfront. Stock futures are often sold on margin. This means that you can secure the contract for a deposit of usually 10-20%. This allows investors to take much larger positions than they typically could if they were to buy the stock outright.

Stock Futures v.s. Stock Options

Stock futures and stock options are two terms that can often get confused. There's one key difference between the two to look out for. Both allow you to buy stocks in the future at a set price and on a set date. However, stock futures are a binding contract that obligates you to follow through with the purchase. On the date specified, you have to buy the stock at the agreed price.

Stock options, on the other hand, give you the right to buy the agreed stock at the set price and date but do not obligate you to buy them. Options allow you to let the contract run out with no purchase made.