Futures: A Guide to Understanding Future Contracts

Unlock the meaning of futures contracts: a comprehensive guide to understanding and trading futures

What are Futures?

Futures, also known as futures contracts, are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. The asset could be a physical commodity or a financial instrument. Futures contracts detail the quality and quantity of the underlying asset and are standardized to facilitate trading on a futures exchange.

Uses of Futures Contracts

Futures contracts are used for two main purposes: hedging and speculation.

Hedging with Futures

Hedging involves taking a position in the futures market that is opposite to a position in the physical market to reduce the risk of financial loss from adverse price changes. For example, a farmer might sell futures contracts for wheat if he believes the price will go down in the future. By doing so, he locks in a price for his crops and is protected if the price of wheat falls.

Speculation with Futures

Speculators are traders who attempt to profit from price changes in futures contracts. They have no desire to own the underlying asset. Instead, they hope to buy futures contracts low and sell them high (or vice versa) to make a profit.

How Futures Contracts Work

Futures contracts are traded on futures exchanges, which act as a marketplace between buyers and sellers. The terms of the contract are standardized by the exchange, but the price is determined by market conditions.

When a futures contract is first entered into, the buyer agrees to pay the agreed-upon price on the delivery date, and the seller agrees to deliver the asset at that time. This is known as “going long” for the buyer and “going short” for the seller.

Settlement of Futures Contracts

Futures contracts can be settled in two ways: physical delivery or cash settlement.

  • Physical Delivery: The seller delivers the underlying asset to the buyer on the delivery date. This is common in commodities markets.
  • Cash Settlement: The seller pays the buyer the cash value of the contract at expiration. This is common in financial futures.

Key Features of Futures Contracts

Futures contracts have several key features that distinguish them from other financial instruments.

  • Standardization: Futures contracts are standardized in terms of the quality, quantity, and delivery date of the underlying asset. This makes them easier to trade.
  • Leverage: Futures contracts are leveraged instruments, meaning traders can control a large amount of the underlying asset with a small amount of capital.
  • Marking to Market: Futures contracts are “marked to market” daily. This means the change in the value of the contract is settled at the end of each trading day.

Risks Associated with Futures Contracts

While futures contracts can be used to manage risk, they also come with their own set of risks. These include market risk, liquidity risk, and the risk of default by the other party. It’s important for traders to understand these risks and manage them effectively to be successful in the futures market.

In summary, futures contracts are a versatile financial instrument used for hedging risk and speculating on price movements. They offer a high degree of leverage but also come with significant risks. Understanding how futures contracts work is essential for anyone interested in trading them.


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