Stock Futures Explained Using Oompa Loompas and Chocolate

If watch or read anything from the financial media in the morning you’ll often hear them get all hot and bothered over the stock futures.

Ever wonder what, exactly, stock futures are? And, more importantly, whether or not they can help you make money in the markets?

If so, then buckle up Buttercup. We’ll answers those questions and more about stock futures starting now…

What Is a Future?

Before digging into stock futures, let’s talk about plain Jane, run o’ the mill “futures” and how they work.

A future is basically a bet. Now investors don’t like using the term bet. They’d prefer you call it a contract. Which, technically, it is.

But it’s really a bet on the future prices of a commodity.

Like, for example, candy.

Say you own a bakery. One of your biggest sellers is your brownies. And the secret ingredient in those brownies is Wonka chocolate. To meet demand you have to buy huge quantities of Wonka chocolate.

You catch wind of rumors of an Oompa Loompa strike in the next few months. If that happens, you expect chocolate prices to go through the roof which is gonna hurt your business.

To protect yourself against higher prices, you can get a futures contract. That futures contract is an agreement for you to buy specific amount of Wonka chocolate for a specific price on a specific date in the future.

To make this more real, let’s say this futures contract states that you agree to purchase 1000 pounds of chocolate for $5 a pound in July of 2022.

Your “bet” is that you believe Wonka chocolate is gonna cost more than $5 in July 2022. If you’re right, you’ve saved your bakery biz some money. If you’re wrong, you’re gonna pay more than the market rate. Which sucks but, hey, in betting you win some and you lose some.

At the end of the day, the futures contract helps you since you can lock in a fair price and protect yourself from a huge price spike if those ungrateful Oompa Loompas walk out. It can also help Wonka by locking in a guaranteed sale of chocolate in the future for what they also believe to be a fair price.

So everyone’s happy (except for the Oompa Loompas).

In the real world, futures are usually traded on things like corn, oil, soybeans and currencies. Besides commodities, futures can also be traded on a stock market index or even individual stocks. Which brings us back to Stock Futures.

Stock Futures Explained

Each day, stock futures start trading on the Chicago Board of Trade a little over an hour before the stock market opens. One of the more common futures is the Dow Future which is based on the Dow Jones Industrial Average (DJIA).

The trading of futures is basically investors betting on the direction they think the stock market will be headed. Some investors, and the financial media, pay close attention to the futures each morning to get an idea of what the stock market will do when it opens that day.

If the stock futures go up, then there’s an above average chance the market will open higher. If they go down, there’s an above average chance the market will open lower.

However, like the voodoo woman who will tell you your future by squeezing a goat’s testicles, the stock futures don’t perfectly predict the future. They give you an indication, yes. But the market can very easily close in the opposite direction the futures predict.

Investing in Stock Futures

While most people use stock futures to get a sense of market sentiment, there are investors who trade them to try and make some dough.

You can bet either way with futures… you can be a buyer of Dow Futures if you think the DJIA is movin’ on up or you can be a seller if you think it’s movin’ on down.

Stock Futures Leverage

Another key thing to note about the value of a Dow Future is that it’s 10 times the actual DJIA. So if the DJIA is sitting at 20,000, a Dow Future is worth $200,000.

The good news is that Dow Futures have leverage built in so you wouldn’t have to pony up $200,000 to buy one. And, since you get $10 for every $1 the Dow goes up, you can make some big returns.

Which means you can also rack up some huge losses.

Which makes investing in them very risky. You can quickly find yourself in the hole for a big chunk o’ change. Even experienced investors can get in trouble since so many unexpected goings-on in the world can impact the price of a stock or the entire market.

The Bottom Line on Stock Futures

Futures are a bet on the expected direction of the price of a commodity, stock or stock market index. Stock futures like the Dow Future are used by many to get an idea of what direction the market is headed when it officially opens for the day. You can also trade futures which, like most risky investments, have the potential to produce huge gains or huge losses.