Futures

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21 Aug, 2024

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Futures Meaning

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.

Futures Meaning

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 asset price, such as a commodity, stock, currency pair, 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 contract, 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 funds, currencies, energy, precious metals, minerals, grains, livestock, food and fiber, stock indices, treasury bonds, 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.

Trading Futures

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 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 hedging:

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.

Futures Examples

Here are a few futures examples to explain how the concept works:

Example #1

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.

Example #2

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 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 instruments. It means traders can also invest in stock futures and exchange traded funds (ETFs). Derivative contracts and futures markets are also common in bonds and cryptocurrencies.

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)

What are futures?

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.

Are futures derivatives?

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.

Are futures high risk?

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.