Introduction

Futures trading is a technique to hedge against or speculate on the future value of all types of assets, such as stocks, commodities, and bonds. It allows you to take advantage of price movements, earning more profits than stock trading. However, the levels of risk are very high.

Understanding what futures are and how they work can impact your portfolio significantly and offer a desirable diversification to your holdings.

What are futures?

In financial markets, the word “futures” refers to futures contracts. A futures contract mentions the clauses for a cash settlement or delivery of a particular asset, such as products, raw materials, or stocks, at a specified date in the future. The contract’s value is derived from the underlying asset’s value, making futures a form of derivatives.

Futures and options are different. A futures contract holder needs to settle the contract. But as an options contract holder, you are not obligated to settle the contract.

You can sell or buy a futures contract. When you sell the contract, you are ready to deliver the underlying asset at the agreed-upon price. Similarly, when you buy the contract, you are willing to pay a specific price on a specific date.

Example of a futures contract

Suppose you are an oil producer desiring to sell oil. You worry that oil prices can fall in the future. What do you do? You use a futures contract to ensure you get a pre-determined price and avoid a loss. A futures contract enables you to lock in the price at which you’d like to sell oil and deliver the oil to the buyer after the contract’s expiry.

Consider another scenario where you are the manufacturer of widgets and require oil for operations. You plan the delivery of the raw material for each month by entering into a futures contract. This way, you will know what price you should expect to receive the oil at based on what’s agreed upon in the futures contract. You can take the delivery of oil upon contract expiry.

Key components of a futures contract

Gaining knowledge about the key components of a futures contract is vital to making informed investment decisions in the market.

1. Underlying asset: The asset on which the futures contract depends is known as the underlying asset. It can range from commodities to financial instruments.

2. Contract size: Futures contracts have standard sizes that indicate the quantity of the underlying asset. Such standardisation helps in seamless trading on organised exchanges.

3. Expiration date: The expiration date for every futures contract is specified and represents the date of contract settlement. You can pick contracts with different expiration dates depending on your trading strategies.

4. Futures price: This price refers to the price of the underlying asset agreed upon by the buyer and seller.

How does futures trading work?

Futures trading focuses on benefiting from price movements or hedging commodity price-fluctuation risks. You can trade four different assets in the futures market - stocks, commodities, currency pairs, and indices.

Hedges and speculators participate in futures trading. Hedgers use futures contracts to stay protected from the risk of price fluctuations in the underlying asset. Generally, hedgers include individuals or businesses who deal in the underlying cash commodity. For instance, as a wheat farmer, you can use a wheat futures contract to define a selling price before the harvest and ensure a steady income even during market fluctuations.

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Speculators, on the other hand, envision profit from price movements. As a speculator, you predict whether prices will rise or fall and take positions based on your market forecasts.

Difference between a futures contract and a forward contract

Futures contracts are standardised, whereas forward contracts are traded over the counter (OTC) with options for customisation. A futures contract has the same terms of buying and selling, while a forward contract is subject to a higher counterparty risk.

Final thoughts

In the world of finance, futures contracts have a critical role to play. The standardised agreements are traded on organised exchanges and offer an excellent way to help you diversify your portfolio. They allow you to use your knowledge and earn higher returns by speculating on future prices. With a futures contract, you can hedge your losses effectively in other asset classes and take delivery of the underlying asset before expiration.

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