Futures contracts or simply Futures are derivatives as they derive their prices from an underlying asset. Futures are traded in standardized forms and are regulated by the Commodity Futures Trading Commission (CFTC).
Futures can be used for hedging and speculation. Once agreed, Futures become an obligation to exercise the contract on the expiration date. However, the contracts can be cash-settled for net difference as most of these contracts are used for speculations.
What is Futures Contract?
A Futures contract is a legal financial contract between two parties to buy or sell an underlying asset on a future date and at a predetermined price. Investors can invest with a right to buy or sell at a future date. However, once agreed, it becomes an obligation to close the contract on a specified date.
In a Futures Contract, both parties undertake an obligation to buy and sell the underlying asset simultaneously. The buyer has an obligation to buy the asset, and the seller has an obligation to sell the underlying asset on the contract expiry date.
The actual delivery of the asset depends on the nature of the Futures Contract, though. As many investors only use Futures for speculations, the seller may also settle for a net cash flow settlement only. However, if the contract was for a commodity delivery, the seller would need to deliver the commodity at the predetermined price.
How Do Futures Contracts Work?
Futures contract legally binds the sellers and buyers of the contract to complete the transaction on a specified date and price. Both parties would settle the contract regardless of the price movement of the underlying asset.
A clearing house facilitates both parties in Futures trading. Although the contract is directly between the buyer and the seller, the clearing house takes the responsibility of facilitating the contract. In practice, the clearing house will settle the net cash flow and receive a commission for offering the services. Thus, the risks and benefits are transferred to sellers and buyers.
Futures are highly leveraged instruments. It means investors only require about 10-15% of the contract value as initial margin. However, if the underlying asset loses value, the clearing house or the broker may ask for additional funds as maintenance margin.
Futures Contracts can be made for several types of assets:
- Stock index futures
- Commodity Futures such as oil, corn, etc.
- Precious metal Futures such as gold or silver
- Currency exchange Futures
- US treasury bond Futures
Uses of Futures Contracts
Investors use Futures for mainly two purposes; Hedging and speculation.
Futures for Hedging
Investors, individuals, and companies use Futures to protect themselves against adverse price movements of assets. Futures are useful instruments that can be used to mitigate market risks.
For example, a crude oil producing company may use Futures to protect itself against declining oil prices in the future. At the same time, an oil-importing company may use Futures to lock in the current market price to save additional costs if it anticipates an increase in oil prices in the coming days.
Futures can be used for hedging for literally any asset or commodity. Currency, commodity, and interest rate Futures Contracts are commonly used as hedging tools.
Futures for Speculation
Traders can use Futures for speculations and make profits. Futures are highly leveraged instruments. It means traders require low investment for trading Futures. Futures are also highly liquid instruments.
Investors with a long position would make money if the underlying asset appreciates by the expiry date of the Futures contract. An investor takes a long position and closes it with an exactly opposite position to balance the contract amounts. The net of price movement is settled on the contract expiry date.
Similarly, when an investor takes a short position on a Futures contract, it will benefit the investor if the asset depreciates. The investor would take a counter position, in the same way, to close out the premiums. The net of cash flows is settled at the expiry date.
Example
Suppose the crude oil is trading at $ 55 today. You anticipate an increase in the crude oil price and take a long position on it. You buy a December Futures contract for the crude oil. You buy one standard Futures contract. It means your total investment is $ 55,000 (1,000 × $ 55).
By December, if the crude oil increases in price as you anticipated, you’ll make money. Suppose the crude oil reaches $ 65 by December. Hence, your profit on the Futures contract will be $ 10,000 less commission for the clearing house or the broker.
You can take a similar approach with a short position if you anticipate a fall in the crude oil price. You’ll make money with a short position if crude oil falls by the contract expiry date.
Advantages of Futures Contracts
Futures can offer several advantages to investors.
- Futures can be used as hedging or speculation instruments.
- These are highly leveraged instruments. Futures are also highly liquid.
- Futures trade in a volatile market. That offers higher profit opportunities.
- Futures can be used for several asset classes, including commodities.
- Commissions and trading costs with Futures are low.
Disadvantages of Futures Contracts
Futures also offer some disadvantages.
- Investors may need to deposit additional funds for maintenance margins.
- High volatility in the Futures market means higher risks too.
- Both parties are contractually bound to complete the transaction.
- Companies may lose money by hedging through Futures if prices do not move favorably.
Final Thoughts
Futures are highly leveraged and liquid instruments. Investors can use Futures for hedging and speculations. Both parties are contractually bound to complete the transaction at the expiry date.
