Futures refer to derivative contracts or financial agreements between the two parties to buy or sell an asset in a particular quantity at a pre-specified price and date. The underlying asset in question could be a commodity (farm produce and minerals), a stock index, a currency pair, or an index fund.
The futures contracts legally bind traders to transact an asset, irrespective of its current market price. These are useful for speculators and hedgers, who use price fluctuations to maximize profits or minimize losses. Furthermore, they can trade them at an already decided rate until the contract expires and settle their positions in cash or via physical delivery.
Table of contents
- Futures are financial derivatives agreements that allow traders to buy or sell an underlying asset in a specific quantity at a predefined price and date in the future.
- The option to fix asset prices in advance allows investors and traders to increase profits (peculation) or mitigate losses (hedging) caused by underlying asset price changes.
- Futures trading can involve index funds, currencies, energy, precious metals, minerals, grains, livestock, food and fiber, stock indices, cryptocurrencies, and treasury bonds.
- Derivative instruments differ from options in that buyers and sellers are legally obligated to buy and sell an underlying asset at the contract expiration, regardless of current market condition.
How Does Futures Work?
Futures are financial derivatives, and their value depends on the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. price, such as a commodity, stock, currency pairCurrency PairA currency pair is a combination of two different national currencies valued against one another. Its purpose is to compare the value of one particular nation’s currency to another., or index. Thus, if the value of the underlying asset increases, the derivative instrument price will increase and vice-versa. The buyer usually takes a long position in a derivative contractDerivative ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based., while the seller takes a short position. The agreement requires traders to trade a specific quantity of an underlying asset at the predetermined price and date.
A standardized futures exchange acts as a marketplace for traders to trade these contracts. A few popular markets include the New York Mercantile Exchange, the Chicago Mercantile Exchange, the Chicago Board of Trade, the Minneapolis Grain Exchange, etc. These exchanges also determine the settlement of trade in cash or physical delivery. Apart from the two parties, the clearinghouse is also involved in the derivative contract. This entity keeps a check on if the transactions are happening as expected and within the expiry date.
The different types of futures include index fundsIndex FundsIndex Funds are passive funds that pool investments into selected securities., currencies, energy, precious metals, minerals, grains, livestock, food and fiber, stock indices, treasury bondsTreasury BondsA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company., etc. Derivative instruments are different from options in that the buyers and sellers are legally bound to buy and sell an underlying asset upon contract expiration. Typically, the positions held until the contract expires are settled in cash. On the other hand, keeping holdings upon contract expiration would necessitate trade settlement in physical delivery.
Buyers and sellers sign derivative agreements at a fixed price to trade a particular quantity of an asset. Every contract comes with an expiry date (usually a month), and the parties need to settle the transaction before it. The price and expiry date of trading the asset in question remain unaffected by the fluctuations in the market. Both parties are legally bound to transact even if they incur huge losses.
For instance, a futures market trades wheat with a predetermined rate of $50 per unit. If the current wheat price is $70 per unit, the buyer will profit, but the seller will lose money. However, the seller would still be obliged to fulfill the contract terms. If the case is vice-versa, the buyer will have to buy the commodity at a high price despite its lower current market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price..
It is also worth noting that while the buyer can only acquire or settle the trade at expiration, they can sell their stake at any time before it expires.
Uses For Futures
Futures are beneficial to seasoned investors and companies as they use them to speculate or hedge in the market. The ability to set asset prices in advance allows them to profit or mitigate risks, irrespective of current market condition. Let us see how futures trading works for speculation and hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.:
- Speculation: Speculative investors trade derivative instruments to predict the underlying asset price movement and profit from it later.
- Hedging: Investors trade derivative instruments to reduce the risk of losses against unfavorable changes in the underlying asset price.
Here are a few futures examples to explain how the concept works:
Ketty, who runs a bakery, requires flour in bulk to prepare different types of cakes. The flour needed to prepare one cake costs her around $6, while she sells her cake for $10. Thus, her profit per cake is $4. However, she fears that if the flour price rises to $8 or $10, her profit percentage will decrease or become zero.
Thus, she opts for a derivative contract and books the flour in the required quantity for the same price per unit until the coming year. As a result, she knows that even if the value of the flour increases to $ 10 or $12, she can still buy it for $6 until the contract expires.
George, a corn grower, is worried about the crop price going down at the end of the year, thereby making him incur a massive loss on selling it. Thus, George signs a derivative contract to hedge the risk. He sets the price of corn per unit at $5. In December, the cost of the grain decreases to $2.50, which creates a problem for many other cornfield farmers. But George remains safe as he could sell it to the interested buyer involved in the deal at the same price without losing anything.
How To Invest In Futures?
Investors and traders must know a few things before investing in derivative instruments, such as its:
- Use for speculation and hedging
- Benefits and high risk for day tradersDay TradersThe day trader is an individual who trades in the financial markets daily to earn profits by exploiting the inefficiencies present in the market. The three types of traders are - individual traders, financial institution traders, scalpers and momentum traders.
- High leverage, and
- Initial margin deposit, i.e., a percentage of the contract price
Futures investing is popular in the commodities market. While commodities like wheat, corn, etc., play a significant role in futures trading, one cannot ignore the contribution of other financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.. It means traders can also invest in stock futures and exchange traded fundsExchange Traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange. (ETFs). Derivative contracts and futures markets are also common in bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period. and cryptocurrenciesCryptocurrenciesCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service..
Traders can trade in a better position despite only investing a modest amount of money. Even while futures trading reduces the risk, it is still a risky endeavor. People assume the asset prices to move in their favor, so they invest in it. And to do so, they often borrow a large sum of money but end up losing all of it.
As a result, experts advise traders to learn about derivative instruments, appraise the market appropriately, and avoid making investment decisions solely based on assumptions.
Frequently Asked Questions (FAQs)
Futures are financial contracts signed between two parties interested in buying or selling an asset in a particular quantity and at a predetermined price and date. It makes the parties involved in the agreement legally bound to settle the transaction, even if they reap a profit or incur a massive loss out of the deal. Futures investing occurs in commodities, index funds, currency pairs, minerals, stock indices, cryptocurrencies, and treasury bonds.
Yes, futures are derivatives as they derive their value from an underlying asset. For example, the price of energy fuel rises based on the price of crude oil. Thus, in this case, energy fuel is a derivative whose price varies with the cost of crude oil, which is the underlying asset.
Yes, investing in futures is risky. It is because, for every contract, there is a buyer and a seller. If the buyer profits because of a lesser predetermined price, it will surely be a loss for the seller as they will have to sell the asset despite the higher current market price before the expiry of the contract.
This has been a guide to the Futures and their meaning. Here we discuss how does futures trading works, examples, uses, and how to invest in them. You may also learn more about financing from the following articles –
- Futures MarketFutures MarketA futures market is a financial marketplace where participants trade futures contracts for commodities, stock indices, currency pairs, and interest rates at a pre-determined rate and agreed-upon future date. It, thus, protects investors and traders from losing money on a transaction even if the price of the commodity or financial instrument rises or falls later.
- Derivatives MarketDerivatives MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets.
- Equity DerivativeEquity DerivativeEquity Derivative is a class of derivatives whose value is connected to the price variations of the underlying asset & it is generally used for hedging risk or speculating moves in indexes. It has 4 major types, i.e., Forwards & Futures, Options, Warrants, & Swaps.