Futures Contracts: What Are They and Why Do We Need Them
Written by: smm
In the modern era, futures have become one of the most popular and widely used instruments that are traded on financial markets. Speculative trading, as well as risk management against price fluctuations, are both common uses for these instruments.
In essence, futures contracts basically determine a fixed price at which the asset will be bought or sold, regardless of how the market might shift between now and the time at which the transaction takes place.
Trading on this instrument as well as the futures market each has its own distinctive characteristics that require the trader to possess particular knowledge and abilities.
So, what are futures:
A standard contract for the purchase or sale of an asset at a predetermined price and settlement on a specific future date is known as a futures contract.
The primary elements of a futures contract are these:
— Asset (commodity, financial instrument, etc.)
— Price per unit of the asset, which will remain constant throughout the term of the contract
— Execution date
— Contract size, which refers to the smallest quantity of the asset that can be purchased or sold under the contract.
Speculative trading of the futures offers market players the chance to make a lot of money, but it also carries a high risk due to market volatility and the potential for capital loss. Aside from that, you need to have technical analysis expertise and knowledge of financial markets to trade futures profitably.
Types of futures:
There are different types of futures, which can vary depending on the underlying asset, the expiration date, when obligations must be met, and the trading exchange.
Based on the type of underlying asset, futures can be broken down into:
1. Financial Futures
Contracts for the purchase or sale of financial instruments such as derivatives, stocks, indices, bonds, and so on.
2. Commodity Futures
Contracts to buy or sell commodities such as grain, oil, gold, silver, metals, and so on.
3. Futures on Goods
Contracts to buy or sell goods such as food, textiles, electronics, and other products.
4. Index Futures
Contracts to purchase or sell a basket of stocks that comprise a specific index, such as the S&P 500, NASDAQ 100, FTSE 100, and so on.
5. Currency Futures
Currency contracts for the purchase or sale of currencies. They can be for a single currency or for currency pairs.
6. Security Futures
Contracts to buy or sell yielding assets such as bonds, loans, etc.
7. Weather Futures
These contracts are closely linked to weather conditions that can affect commodity production and consumption.
8. Cryptocurrency Futures
Contracts to buy or sell digital assets.
Based on the expiration date, we can single out:
1. Monthly Futures
The contract is valid for one month and will expire on a certain date.
2. Quarterly Futures
These expire at the end of a specific quarter, such as March, June, September, or December.
3. Fixed-date Futures
They have a specific expiration date, which can be any day of the week or month.
4. Perpetual Futures
They have no set expiration date and enable traders to keep their positions open indefinitely.
Futures can be roughly broken down into more categories based on the trading platform that supports trading in one or more types of contracts. This provides a useful starting point for further analysis. Futures contracts for cryptocurrencies, for instance, can be purchased on the DEX and CEX, whereas futures contracts for commodities cannot be bought or sold on these exchanges.
That being said, it stands to mention that most exchanges strive to expand the offered list of financial instruments, including more and more available types of futures.
How do futures work:
Futures are used in the following manner:
1. On the futures exchange, a standard contract is concluded stipulating the value, duration, and terms of delivery of the underlying asset.
2. A futures contract is purchased or sold through an agreement between the buyer and the seller.
3. The margin, which can be altered to account for market fluctuations, is the payment made by the buyer of a futures contract to the seller.
4. The buyer can close the contract before the settlement date or sell it on the exchange to another investor if the buyer does not wish to wait for the contract to expire.
5. The owner of a futures contract is required to fulfill its terms by delivering the asset or purchasing it at a predetermined price if the owner decides not to sell it before the end of the term.
Why do we need futures:
Futures are primarily used to hedge against potential changes in an asset’s price.
We shall use an example to illustrate how this works in practical terms.
Let’s imagine the following situation: wheat was planted in April, and the farmer will need to gather his crop in August. He is worried that wheat prices will have dropped by August, which, in turn, would reduce revenue from the harvest. The baker, on the other hand, is concerned that wheat prices may rise in the future, thus increasing his costs.
The farmer and the baker negotiate a price that they hope will prevent future disagreements over pricing. They agree that the farmer will sell the wheat to the baker in August for $200 per ton. In a nutshell, this is what a futures contract is.
That being said, the baker is still buying wheat at a cost of $200 per ton because of the futures contract. At the same time, the farmer ensures himself a consistent income despite the fluctuations of the market prices. The baker will still have to purchase wheat at the predetermined price even if its cost totals $190 per ton in August.
Whether it is advantageous to them or not, futures contracts are legally binding, and both parties are required to uphold their responsibilities.
As a result, by fixing prices in advance and ensuring the stability of their operations, futures trading enables market players to protect themselves from the risk of price changes.
Keep in mind that the vast majority of futures contracts are settled not through the physical delivery of goods but through the closing of positions prior to the expiration of the contract. Before August arrives, the baker can sell his contract on the exchange and have another market participant buy it, protecting him from a loss.
Futures can be used for both hedging against potential losses and speculative trades in which buyers and sellers bet on future price movements.