What Are Futures Contracts?
Futures contracts are standardized legal agreements to buy or sell a specific
asset at a predetermined price at a specified time in the future. These contracts are typically traded on
exchanges and are used by both
speculators and
hedgers to manage risk, speculate on price movements, or lock in prices.
How Do Futures Contracts Work?
In a futures contract, the buyer agrees to purchase, and the seller agrees to sell, a specific quantity of an asset at a set price on a future date. The
underlying assets can include commodities like oil, gold, and wheat, as well as financial instruments like currencies, interest rates, and stock indexes.
Unlike
options, which give the holder the right but not the obligation to buy or sell, futures contracts obligate both parties to fulfill the terms of the agreement. Most futures contracts are closed out before the delivery date, meaning that physical delivery of the underlying asset rarely occurs.
Hedging Risk: Companies use futures to hedge against adverse price movements in commodities or currencies. For example, an airline might use futures contracts to lock in the price of jet fuel.
Speculation: Traders use futures contracts to profit from price movements. By taking a long or short position, speculators can bet on the direction of the market.
Price Discovery: Futures markets provide a transparent mechanism for price discovery, reflecting the collective market sentiment about the future value of an asset.
Leverage: Futures contracts allow traders to gain significant exposure to an asset with a relatively small initial investment, known as the margin.
Contract Size: The quantity of the underlying asset covered by the contract.
Expiration Date: The date on which the contract must be settled.
Tick Size: The minimum price movement of the contract.
Margin Requirements: The amount of money that must be deposited to open a position.
Settlement Method: Specifies whether the contract is settled by physical delivery of the asset or by cash settlement.
Market Risk: The value of the contract can fluctuate significantly, leading to potential losses.
Leverage Risk: The use of leverage can amplify both gains and losses.
Liquidity Risk: Not all futures contracts are highly liquid, which can make it difficult to enter or exit positions without affecting the price.
Counterparty Risk: Although exchanges mitigate this risk, there is still a possibility that the counterparty may default on the contract.
Conclusion
Futures contracts are powerful financial instruments used for hedging, speculation, and price discovery. While they offer significant advantages such as risk management and leverage, they also come with substantial risks. Understanding the mechanics, benefits, and risks involved is crucial for anyone looking to engage in futures trading.