What Are Futures?
Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset, such as a commodity or financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
Understanding Futures
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase, or the seller must sell the underlying asset at the set price, regardless of the prevailing market price at the expiration date.
To exit the commitment before the settlement date, the holder of a futures position can close out its contract by taking an opposite position on the identical contract.
Types of Futures Contracts
Futures contracts exist on financial indices, commodities, bonds, and currencies. Investors use these contracts for hedging risk or speculating on the price movement of the underlying asset.
Futures can be used to hedge or speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk, or anybody could speculate on the price movement of corn by going long or short using futures.
Advantages and Disadvantages of Futures
Futures contracts are highly standardized, with clear, transparent terms and conditions. They trade on centralized exchanges, providing liquidity and convenience for market participants.
However, trading futures also carries a high level of risk. They are leveraged instruments, meaning that a small amount of capital can control a large position. This can lead to significant gains or losses, possibly exceeding the initial investment. Therefore, futures trading may not be suitable for all investors.
Real World Example of Futures Trading
For example, suppose a trader buys a futures contract for gold. They are agreeing to buy gold, at a specified price, on a specified date. If the price of gold rises between the purchase date and the expiration date, the trader can sell the futures contract for a profit. If the price of gold falls, the trader will incur a loss.
The Bottom Line
Futures contracts are standardized agreements to buy or sell assets at a predetermined price at a specified time in the future. They provide investors with a way to hedge risk or speculate on the price movement of an asset. While futures trading offers opportunities for profit, it also carries a high level of risk and may not be suitable for all investors.
