What Are Futures?
Futures are financial contracts that are derivative which bind parties to purchase and sell assets on the specified future date and at a certain price. The buyer is required to purchase or sell the asset in question at the specified price regardless of the market value at the time of date of expiration.
The underlying assets are financial instruments and physical commodities. Futures contracts provide the amount of the asset underpinning it as well as are standardized to ease trading on the futures exchange. Futures are a great option to hedge or for speculation on trade.
Understanding Futures
Futures, also known as futures contracts, permit traders to lock in the cost of the actual commodity or asset. They have expiration dates and fixed prices that are upfront. Futures are defined by the month they expire. For instance, a December Gold futures contract is due in December.
Investors and traders alike make use of the term “futures” in reference to the entire asset class. There are a variety of kinds of futures contracts that are available to trade, including:
- Commodity futures based on commodities like natural gas, crude oil and corn.
- Stock index futures that have underlying assets, such as S&P 500 Index. S&P 500 Index
- Futures for currency such as those for the euro as well as the British pounds
- Precious metals futures for silver and gold
- U.S. Treasury futures for bonds and other financial securities
It’s crucial to know the difference between futures and options. Options contracts that are American-style allow the holder to exercise the right (but but not an obligation) to purchase or sell the asset at any time prior to that date on which the contract expires. If you are using European choices, the holder are able to only exercise your right at expiration and you are not required to exercise your right.
The person who buys the futures contract on the other hand is required to acquire the item (or an equivalent financial product) at the time of expiration , and not earlier than. A buyer who buys a contract for futures may sell their positions at any time prior to expiration, and free of the obligation. This way buyers of both futures and options contracts can benefit from a position that is closed by a leverage holder prior to expiration day.
Using Futures
The market for futures usually uses high leverage. Leverage is the term used to describe the fact that a trader doesn’t have to pay 100 percent of the contract’s value amount before entering into a transaction. Instead, brokers would need to provide an initial margin amount comprised of just a portion of the amount of the contract.
The exchange on which the contract for futures trades determine whether the contract is physically delivered or if it’s cash-settled. A business can enter into the physical delivery contract in order to guarantee the price of a product that it needs to produce. However, many of these contracts are based on speculation by traders on the trading. The contracts are closed or netted – the difference between the trade’s price at the beginning and closing price of the trade–and offer the option of cash settlement.
Futures for Speculation
A futures contract permits traders to bet on the price of a commodity. If a trader purchased an option to buy a futures contract, and the value of the commodity increased and was trading over the price of the contract at expiration, they’d make a profit. At the time of expiration, the contract, also known as the long position, would have to be traded at today’s price, thereby closing this long-term position.
The difference in price will be settled in cash into the brokerage account of the investor, and no physical item could be exchanged. But, the trader might also lose money if the price of the commodity was lower that the price stated in the contract for futures.
Speculators may also opt for an speculative short position in the event that they believe the value of the asset in question will decrease. If the price falls then the trader can make an offsetting move to end the contract. The net difference will be settled upon the expiration of the agreement. A buyer would earn a profit if the asset’s value was lower than the value of the contract and a loss in the event that prices were greater than the price of the contract.
It’s crucial to know that trading on margins permits a greater account than that of money in your brokerage account. This means that margin investing can increase gains, but it could also make losses more severe.
Imagine a trader with an account balance of $5,000 and has a $50,000 stake of crude oil. If the oil price moves to the downside, that could cause losses that exceed the initial margin of $5,000 amount. In this situation the broker will issue an order to make a margin call, requiring additional funds be put in place to offset the losses on the market.
Futures for Hedging
Futures are a great way to protect against the price fluctuations of the asset that is the source. The goal here is to avoid losses due to possible price swings that could be detrimental rather than speculate. Many firms that participate in hedges are using or in many cases , creating the asset.
For instance, corn farmers can utilize futures to lock in a particular price to sell their crop of corn. In this way they lower their risk and ensure that they will be paid the set price. If the cost of corn fell in the future, the farmer will earn an income from the hedge, which would compensate for the loss from selling the corn on the market. With a gain and loss balancing one another, the hedge effectively guarantees a fair market value.
Example of Futures
Let’s say that a trader wishes to speculate about the price for crude oil, by committing to an option contract for futures in May, with the assumption of the cost to increase at the close of the year. In December, the crude oil forward contract trades at $50, and the trader decides to buy the contract.
As oil can be traded at 1,000 barrel increments The investor has an account worth $50,000 of crude oil (1,000 50 x $1,000 equals $50,000).
The trader would only be required to pay a small portion of this amount upfront–the initial margin they put in with the broker.
From May until December, the cost of oil fluctuates according to its value in the contract for futures. If the price of oil becomes too fluctuating, the broker could require additional funds be deposited in the account of margin. This is referred to as maintenance margin.
This month, December’s expiration day of contract nearing (the 3rd Friday in the month). The cost for crude oil increased to $65. The trader then sells the initial contract to close the position. The difference in net is settled with cash. They will earn $15,000, less commissions and fees due to the broker ($65 $150 – $15 = $15 15,000 x 1000 = $15,000.).
If, however, the price of oil had dropped to $40 instead investors would’ve lost $10,000 ($50 + $40 = 10 x 1000 = a losing $10,000).