Understanding Futures Contracts

Understanding Futures Contracts

What Is a Futures Contract?

An agreement to purchase or sell an underlying asset at a later time for a fixed price is known as a futures contract. Because future contracts get their value from an underlying asset, they are also referred to as derivatives. For a specific price, investors can purchase the right to purchase or sell the underlying asset at a later time.

An investor hopes to profit from a rise in the underlying asset’s price by acquiring the right to buy. The investor hopes to benefit from a drop in the value of the underlying asset by acquiring the right to sell. 

The right to purchase would benefit a financial analyst in the event that the value of the underlying asset rose. After purchasing the futures contract, the investor would then be able to exercise his right to purchase the item at the lower price and resell it at the higher current market price.

The option to sell an asset at a lower price to investors is a profitable one. The asset would be sold by the investor at the higher market price guaranteed by the futures contract, and it would then be purchased again at the lower price.

Who Are Futures Contracts Traded by?

Futures contract traders can be divided into two categories: hedgers and speculators.

Hedgers

These companies or people utilize futures contracts to hedge against erratic fluctuations in the price of the underlying commodity.

A corn farmer and a maize canner would be excellent examples of hedging. Protection from falling corn prices is what a corn farmer would want, and protection from rising corn prices is what a corn canner would desire. In order to reduce the risk, corn would be purchased by the corn farmer as the right to sell corn at a later time for a set price, and by the corn canner as the right to purchase corn at a later time at a certain price.

Everybody takes a side in the agreement. The farmer and the canner share the risk of fluctuating prices by hedging.

Let’s examine the transaction from the perspective of the farmer. In the farmer’s case, he fears that by the time he comes to harvest and sell his crop, the price of corn would have dropped considerably. He sells short several December corn futures contracts in July, almost equivalent to the amount of his anticipated yield, in order to mitigate the risk.

Contracts for December futures refer to deliveries of the commodity in December. In July, the market price of maize is $3 per bushel when he sells short. In the same manner that stocks can be sold short, the farmer is doing the same with corn futures. 

By December, corn is selling for just $2.50 a bushel on the market. The farmer closes out his futures contract trade by purchasing the contracts back at the lower price of $2.50 after selling his maize for the going market price of $2.50 per bushel.

He made up the 50-cent market price loss by making a 50-cent profit per bushel on his futures deal because he had sold short at $3. The farmer would have received fifty cents less per bushel for his corn crop if he had not hedged it with futures contracts.

In this instance, the corn canner who purchases December corn futures in July will profit by being able to purchase corn on the open market in December for just $2.50 per bushel, but he will lose 50 cents per bushel on his futures trade.

By using futures contracts to effectively lock in a price of $3 per bushel in July, both the farmer and the canner are shielding themselves from a significant unfavorable price fluctuation.

Speculators

Speculators are self-employed investors and traders. While some traders use their own funds, others trade on behalf of brokerage houses or prop trading firms. Just like they trade stocks or bonds, speculators also trade futures contracts.

Futures contracts have the following benefits over other types of investments: 

  • The futures market is more volatile than other markets. Prices for futures typically fluctuate more than those for stocks or bonds. This gives traders additional opportunity to profit from short-term price movements in the futures markets, but it also entails increased risk.
  • Investments with a lot of leverage are futures. The trader can ride the full value of the contract as the price moves up and down, but he usually only needs to put up 10%–15% of the value of the underlying asset as margin. As a result, he can trade more (and in bigger quantities) for less money.
  • In comparison to other investment options, commission fees on futures trades are minimal.
  • Markets for commodities are highly liquid. Quick transaction completion lowers the possibility of market volatility between decision and execution.

The Clearing House

By taking the other side of every trade, a clearing house facilitates transactions involving futures and other derivatives. A clearing house is a type of financial organization established with the express purpose of enabling derivative transactions.

A futures contract is not a true contract between two parties. Rather, it is an agreement between them. By taking on the credit risk associated with transactions, the clearing house functions as a guarantor. The clearing house will not, however, assume the market risk. 

As a result, every day, gains and losses will be moved to and from the clearing house to the corresponding parties’ accounts.

Bottom Line

Since futures contracts usually do not have a favorable correlation with stock market prices, they are seen as an alternative investment. Investing in commodities futures gives investors access to a different asset class. Although there are benefits to futures trading, such as minimal trading expenses, there is also a larger risk due to increased market volatility. Exercising the right trading strategy is key.

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