Definition
Futures contracts are derivative financial agreements obligating the buyer to purchase an asset, or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price.
Understanding Futures Contracts
Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.
Futures Contracts Explained
A futures contract is a legal agreement between two parties to buy or sell an asset at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
Futures Contract Terms
Futures contracts have expiration dates ranging from one month to several years. Each futures contract has specifications for the commodity, including the minimum price fluctuation and the last trading day. Traders buy and sell futures contracts based on margin, which represents a fraction of the contract value.
Futures Contracts vs. Forwards
Futures contracts are similar to forwards but are standardized and traded on an exchange, while forwards are customized and traded over-the-counter. Both types of contracts mitigate risks by allowing parties to lock in prices for future transactions.
Advantages and Disadvantages of Futures Contracts
Futures contracts offer benefits such as price transparency, liquidity, and leverage, but they also carry risks such as price volatility and the potential for substantial losses. Traders should carefully consider their risk tolerance and investment objectives before trading futures contracts.
Example of a Futures Contract
For example, suppose a farmer expects to harvest 100,000 bushels of corn in six months and wants to lock in the price. The farmer can sell a futures contract for 100,000 bushels of corn at the current market price. If the price of corn decreases before the harvest, the farmer has effectively locked in a higher price.
The Bottom Line
Futures contracts are derivative financial instruments that enable parties to buy or sell assets at a predetermined price on a specified future date. These contracts are standardized and traded on futures exchanges, providing benefits such as price transparency and liquidity. However, futures trading carries risks, and traders should carefully assess their risk tolerance before participating in the futures market.
