What is a futures contract?
A futures contract is a legal agreement to buy or sell a particular commodity asset or security at a given price in the future at a specified time. Futures contracts are standardized in quality and quantity to facilitate trading on futures exchanges.
Futures contract buyers are obliged to purchase and receive the underlying asset when the futures contract expires. The seller of the futures contract is obliged to provide and deliver the underlying asset on the maturity date.
- A futures contract is a financial derivative that requires the buyer to buy the underlying asset (or the seller to sell the asset) at a given future price and date.
- Futures contracts allow investors to use leverage to infer the direction of securities, commodities, or financial instruments, either long-term or short-term.
- Futures are also often used to hedge price fluctuations in the underlying asset and prevent losses due to unfavorable price fluctuations.
How do futures contracts work?
Understand futures contracts
Futures are derivative financial contracts that require parties to trade assets on a given future date and price. Here, the buyer must buy or sell the underlying asset at a set price, regardless of the current market price on the maturity date.
Underlying assets include physical products or other financial products. Futures contracts are standardized to detail the quantity of underlying assets and facilitate trading on futures exchanges. Futures can be used for hedging and trade speculation.
“Futures contract” and “futures” refer to the same thing. For example, you might hear someone buy oil futures. This means the same as an oil futures contract. When someone says a “futures contract,” they usually refer to certain types of futures, such as oil, gold, bonds, and S & P 500 index futures. Futures contracts are also one of the most direct ways to invest in oil. The term “futures” is more common and is often used to refer to the entire market, such as “they are futures traders.”
Futures contracts, unlike futures contracts, are standardized. Forwards are a similar type of contract that fixes the current future price, but forwards are traded over-the-counter (OTC) and have customizable terms reached between counterparties. On the other hand, futures contracts have the same conditions regardless of the other party.
Futures contract example
Futures contracts are used by two categories of market participants: hedgers and speculators. While the producer or purchaser of the underlying asset hedges or guarantees the price at which the commodity is sold or purchased, portfolio managers and traders can also use futures to bet on price fluctuations on the underlying asset.
Oil producers need to sell their oil. They may use futures contracts to do that. In this way, they can fix the price they sell and deliver oil to the buyer when the futures contract expires. Similarly, manufacturers may need oil to create widgets. They also prefer to plan ahead and oil comes in every month, so they may also use futures contracts. In this way, they know in advance the price to pay for oil (futures contract price) and know that they will receive oil delivery when the contract expires.
Futures are available on a wide variety of assets. There are futures contracts for stock exchange indices, commodities and currencies.
Futures contract mechanism
Imagine an oil producer planning to produce a million barrels of oil next year. It will be delivered in 12 months. Suppose the current price is $ 75 per barrel. Producers can produce oil and sell it at current market prices a year from today.
Given the fluctuations in crude oil prices, market prices at that time could differ significantly from current prices. If oil producers think oil will be higher within a year, they may now choose not to fix prices. However, if they think $ 75 is the right price, they can fix the guaranteed selling price by signing a futures contract.
Use a mathematical model to determine the price of futures. It takes into account current spot prices, risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields. Suppose the price of a one-year oil futures contract is $ 78 per barrel. By signing this agreement, producers are obliged to deliver 1 million barrels of oil per year and are guaranteed to receive $ 78 million. Regardless of where the spot market price is at that time, you will receive a price of $ 78 per barrel.
The contract is standardized. For example, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. So if someone wants to fix the price (sell or buy) of 100,000 barrels of oil, they need to buy and sell 100 contracts. To fix the price of one million barrels of oil, you need to buy and sell 1,000 contracts.
The futures market is regulated by the Commodity Futures Trading Commission (CFTC). CFTC is a federal agency founded by Congress in 1974 to ensure the integrity of futures market pricing, including futures trading practices, fraud prevention, and regulation of brokerage firms engaged in futures trading.
How to trade futures contracts
Retailers and portfolio managers are not interested in providing or receiving underlying assets. Retailers rarely need to receive 1,000 barrels of oil, but may be interested in profiting from oil price fluctuations.
Futures contracts can be traded purely for profit as long as the trade is closed before expiration. Many futures contracts expire on the third Friday of the month, but contracts are different, so please check the contract specifications of all contracts before trading.
For example, in January, the April contract is trading at $ 55. If traders believe the price of oil will rise before the contract expires in April, they can buy the contract for $ 55. This will allow you to manage 1,000 barrels of oil. However, you do not have to pay $ 55,000 ($ 55 x 1,000 barrels) for this privilege. Rather, brokers only need to pay the initial margin, usually thousands of dollars per contract.
The profit or loss of a position will fluctuate within your account as the price of futures contracts fluctuates. If the loss becomes too large, the trader will ask the trader to deposit more money to make up for the loss. This is called the maintenance margin.
The final profit or loss of a transaction is realized when the transaction is closed. In this case, if the buyer sells the contract for $ 60, it will be $ 5,000[($ 60- $ 55) x 1,000). Alternatively, if the price drops to $ 50 and you close your position there, you will lose $ 5,000.
Why is it called a futures contract?
The name of the futures contract comes from the fact that the buyer and seller of the contract today agree on the price of an asset or security to be offered in the future.
Are futures and futures the same?
These two types of derivative contracts work in much the same way, with the main difference being that the futures are exchange-traded funds and the contract specifications are standardized. These exchanges are highly regulated and provide transparent contract and price data. In contrast, forwards trade over-the-counter (OTC) with terms and contract specifications customized by the two parties involved.
What if the futures contract is held until it expires?
Unless the contract position is closed before expiration, the short is obliged to deliver to the long and the long is obliged to take it. Depends on …