- Futures contracts allow businesses to lock in prices at which they can sell or buy commodities at a later date.
- Trading futures can help protect your business from unexpected losses, but you can also lose money when trading futures.
- Businesses should consider using futures only if their profits depend heavily on raw goods, like gas, metals or specific ingredients.
- This article is for small business owners who want to learn how the futures market can help protect them from price volatility when they depend on or produce raw goods.
Inflationary pressures can wreak havoc on a small business’s bottom line. For example, if you own a coffee shop and the price of coffee beans increases, you don’t have a choice — you need to pay more for coffee beans to keep your business operational.
If the rising cost of raw materials directly threatens your small business, it may be worth exploring the futures market as a way to hedge against inflation. These financial products can help control your operating costs or lock in your product price. But beware: Investing in futures may be risky, and you could lose money. This guide will explain how to use futures contracts to protect your business’s finances.
What is hedging with futures contracts?
Hedging with futures contracts refers to taking a financial position that opposes your business goals. Doing so controls your risk: If your business suffers, your hedge position will profit, and vice versa. To hedge with futures contracts, you must first identify the commodity you wish to trade and the price you need to pay (or receive) for that commodity.
Tip: Looking for other ways to manage your small business’s finances? These 10 tips can help you shore up your fiscal house and put your business on the right track for success and profitability.
Let’s return to the example of the coffee shop owner in an economy where the price of coffee beans is increasing. After reviewing last month’s numbers, the owner realizes the business can’t afford to pay much more for coffee without losing their desired profit margin. In this situation, the coffee shop owner could consider buying coffee futures contracts.
Buying futures contracts essentially locks in the current price for businesses that need the commodity. If the price of coffee beans continues to rise, the value of the futures contract will increase accordingly. The business will have to pay more for coffee beans, but the profits from the futures contract they own will offset those extra costs.
The previous example dealt with a purchaser, but futures can also be used as a hedge for producers. Let’s consider a soybean farmer. After calculating the costs that went into planting, cultivating and harvesting this year’s crop, the farmer realizes their desired profit margin depends on the price of soybeans remaining consistent with today’s prices.
If the farmer in this situation fears prices will decline, they can sell a futures contract short. This essentially locks in the price at which they can deliver their products. If the price continues to fall, they won’t receive as much money for their crop, but they can make up the lost revenue with their profitable short position.
What kinds of businesses benefit from futures?
Before learning how to use the futures market to control business costs, you must assess whether this is an appropriate strategy for your company. Not all businesses stand to benefit from futures, and there is inherent risk in all investment activities.
FYI: The information here is for educational purposes and not investment advice. Before risking your company’s hard-earned money, consult a financial advisor who can address your specific situation.
When to invest in futures
Businesses that produce raw materials (such as mining companies or agricultural businesses) and those that rely on them to operate (like manufacturers) are most likely to benefit from investing in futures.
To know whether futures could serve your company, consider how much you rely on specific raw goods. Futures contracts represent a transaction for a particular commodity. For example, one RBOB gasoline futures contract is worth 42,000 gallons of gas, according to CME Group. If your business depends on a single commodity, like gas, you can use those futures to control prices.
When to avoid futures
On the other hand, if your business is less reliant on raw materials, futures might not be beneficial. For example, while a coffee shop needs coffee beans, a more diversified restaurant may not have such strict ingredient requirements. A coffee shop must pay higher prices when coffee beans become more expensive, but a restaurant may be able to change its menu to avoid paying higher costs. If the price of apples rises, a restaurant may be able to substitute apples or otherwise tweak its menu, or it could feature dishes without apples in its marketing.
Did you know?: Futures contracts aren’t always tied to commodities. You can trade futures for equity indexes (like the S&P 500), cryptocurrency or foreign currencies, but these products might not have a direct tie to your business operations.
Pros and cons of investing in futures
Hedging with futures isn’t a magic cure for any financial problem your small business faces. In fact, poor investments could result in additional losses. Keep these pros and cons in mind before considering a futures trade:
- Nearly 24/7 access to markets. Unlike the stock market, which trades mostly during standard business hours, futures exchanges trade nearly 24 hours per day from Sunday evening through Friday evening. This gives you a lot of flexibility to adjust your exposure to a commodity. If something happens in the world that impacts a commodity you track (either positively or negatively), you can use futures to buy or sell that commodity almost immediately.
- Wide range of contracts to trade. Futures contracts aren’t limited to major commodities such as oil, coffee beans and soybeans. You can use futures contracts to speculate on many aspects of the world, including interest rates, exchange rates and water. Futures probably offer some way to hedge against your business operations, even if your company depends on relatively obscure products or conditions. Any contract can be bought or shorted, so you can potentially profit regardless of the direction in which prices move.
- Risk of financial loss. At its core, hedging involves speculating about financial markets. If you think prices will go up, you buy a contract; if you think prices will go down, you sell a contract. Correctly guessing what will happen in markets is extremely difficult, and any speculation creates financial risk. In theory, these risks are mitigated by your business. If you lose money when buying a futures contract, you get your ingredients at a lower price. If you lose money when selling a contract, you receive more money for what you produce. However, if you don’t ensure that your futures position is proportional to your business needs, futures trading could result in significant losses.
- Less useful for diversified small businesses. If you have a diversified, flexible business that can draw on a wide range of raw goods, you might not need to hedge with futures. Pivoting to a different product with cheaper inputs (such as a restaurant tweaking its menu) can offer a less risky way to deal with rising prices.
Tip: Always consult with a financial advisor with a fiduciary responsibility to your business before investing in futures or any other financial instrument. Investing is inherently risky, so be sure to fully educate yourself before making any major decisions with your business’s hard-earned money.
How to get started with futures
To start trading futures, you’ll need a brokerage account that gives you access to the futures market. This is similar to a stock brokerage account, and some brokerages may allow you to trade both stocks and futures in a single account.
Depending on how your business is structured, you may be able to open the brokerage account in your personal name, or you may want to open it in your business’s name. If the account is in your company’s name, you’ll need to designate the individuals who are authorized to place trades on your company’s behalf.
Placing futures trades
Once you’ve funded your account and you’re ready to make a trade, you’ll fill out a ticket (typically online or through a mobile app) that specifies the type of trade. There are many types of trades you can place, but they all stem from three major types: market, limit or stop.
- Market orders: These orders execute as soon as possible at the best price available at that moment.
- Limit orders: These orders guarantee a predetermined price – but the order won’t execute until someone is willing to take the other side of your trade, and the order may not execute at all if you set the price too high or too low.
- Stop orders: These orders are typically market orders, but the brokerage doesn’t place the order unless another trade has already been executed at a predetermined price. For example, you may buy a contract at $1,000 and set a stop order to sell at $800. If the price falls to $800, the stop order will execute and you’ll sell the contract almost instantaneously. There are many variations of this order type, including orders with a percentage-based trigger and “trailing” stops that adjust as the price moves in your favor.
Did you know?: Stop orders, often called stop-loss orders, are commonly used to exit your trade when the price moves too far in the opposite direction you’d hoped. “Stopping out” automatically controls your losses so you don’t have to constantly track your trade.
Practice makes perfect
Remember, before you place any futures trades, it’s best to consult an expert. A financial advisor can assess the details of your business to help you understand whether (and how) futures can help you fight inflation, lock in prices when demand falls, or otherwise improve financial stability.
Once you decide that futures may serve your business, use a demo account to practice making trades without risking real money. Practice filling out order tickets. Watch how prices move in response to economic events. Once you’re familiar with how the futures market functions, you can start placing small trades more confidently. As your confidence grows, scale up your position until you finally have full hedge positions that protect your business from inflation, demand destruction and other forms of price volatility.