What is a Futures Contract?
A futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price. By purchasing the right to buy, the investor would expect to profit from an increase in the price of the underlying asset, and by purchasing the right to sell, the investor would expect to profit from a decrease in the price of the underlying asset.
A financial analyst would profit from the right to buy if the price of the underlying asset increases. The investor would then exercise his right to buy the asset at the lower price and resell the asset at a higher market price. Investors would profit from the right to sell if the price of the underlying asset decreases. The investor would buy the asset at the lower market price and exercise his right to sell the asset at a higher price.
Who Trades Futures Contracts?
There are two types of people who trade (buy or sell) futures contracts: hedgers and speculators.
These are businesses or individuals use futures contracts for protection against volatile price movements in the underlying commodity.
A good example to illustrate hedging would be a corn farmer and a corn canner. A corn farmer would want protection from corn prices decreasing, and a corn canner would want protection from corn prices increasing. So, to mitigate the risk, the corn farmer would purchase the right to sell corn at a later date for a predetermined price, and the corn canner would purchase the right to buy corn at a later date for a predetermined price.
Each party takes a side of the contract. Both the farmer and canners pay the cost of purchasing futures contracts, but they hedge their exposure to price volatility.
Speculators are independent traders and investors. Some will be trading using their own money, and some will be trading on behalf of personal clients or brokerage firms. Speculators will trade futures contracts just like they would trade stocks or bonds.
There are a few advantages that futures contracts have over other investments such as stocks and bonds:
- There is greater volatility within the futures market. On average, futures prices tend to change faster than stock or bond prices. However, there is a greater risk.
- Futures are highly leveraged investments. The trade only needs to put up 10%-15% of the value of the underlying asset as margin, but he can ride the full value of the contract as the price moves up and down.
- Futures are harder to trade on insider information. There really is not insider information on whether or any other factors affecting commodities.
- Commission charges on futures trades are small relative to other investments.
- Commodity markets are very liquid. Transactions can be completed quickly, decreasing the chances of market movement between decision and execution.
In practice, a clearing house is used to facilitate futures (and all derivative) transactions by being on the other side of all trades. A clearinghouse is a financial institution formed specifically to facilitate all derivative transactions.
When two parties enter into a futures contract, they are not entering into a contract with each other. Instead, both parties are entering into a contract with the clearing house. The clearing house acts as a guarantor by assuming the credit risk of transactions. However, the clearing house will not take on the market risk. Thus, gains and losses will be transferred to and from the clearing house to the parties accounts on a daily basis.
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