The Definition of a Futures Contract as Well as Its Pros & Cons | Motilal Oswal
The Definition of a Futures Contract as Well as Its Pros & Cons | Motilal Oswal

Definition of a Futures Contract as well as its benefits and drawbacks

A futures contract involves two parties entering into a contract as part of which they agree to buy/sell a certain product/commodity etc., at a predetermined price, at a later point in time. If this definition raises more questions in your mind such as “who are these parties”, “why would they agree to buy and sell at a later date” and “is a futures contract based on speculation”, then answers about the meaning of futures contract, then you are not alone. A simple example holds the potential to clarify the meaning of a futures contract for you and once and for all, after which it will be almost impossible to forget. 

  • An example 

Let's take breakfast cereal as our example. A company buys the corn for the cereal from a farmer and then produces the cereal with it, selling it to customers for a profit. This is a codependent relationship since the company needs the farmers for raw materials, and farmers need the income. Now, if the price for corn increases, this means the company will have to pay farmers more which will increase the costs of production. On the other hand, if the price of corn goes down, the farmers will receive less income for the same amount of corn. Therefore, in order to avoid both these unfavourable situations, both parties enter into a futures contract. 

As part of the contract, they might agree on a price for corn for the next harvest season. If the price goes up, the company can rely on the futures contract in order to get their raw material at a lesser rate due to the contract. If the price for corn goes down, the farmers can rely on the futures contract to get a better price. 

  • The advantages and drawbacks. 

One of the most significant benefits, clear from the example, is the ability to reduce your risk, more commonly known as risk hedging. As we saw in the example above, both parties hedged their risk. While there is one loser and one winner in the contract, both parties stand to lose less than they would without the contract, as they would have to pay the market price. There is also no time decay involved with a futures contract. In addition to this, the high liquidity alongside simple pricing makes the futures market an appealing entity of risk-tolerant investors. 

There are however some downsides, such as the fact that if the leverage taken is too high, the prices of futures contracts will fluctuate greatly. In addition to this, the closer you get to the expiry date of the contract, the less appealing it becomes, meaning you could be getting into a worthless investment, The biggest drawback of all, however, is the inability to predict what will happen in the futures market in the future, meaning you are effectively playing a very educated guessing game. 

Conclusion. 

Futures contracts offer some benefits over equity markets, making them appealing to investors. With high liquidity and no degradation of the underlying asset, the market is open for investors to enter. However, the futures market is best suited for those who have a decent tolerance for risk, as the downside could be high.   Stock Market trading is a very rewarding but also very risky affair, and it is important to know about your investments. 

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