Investopedia
Futures
What Are Futures?
Futures are derivative financial contracts that obligate the parties
to transact an asset at a predetermined future date and price. Here, the
buyer must purchase or the seller must sell the underlying asset at the
set price, regardless of the current market price at the expiration
date.
Underlying assets include physical commodities or other financial
instruments. Futures contracts detail the quantity of the underlying
asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.
Key Takeaways
- Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset and have a predetermined future date and price.
- A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument.
- Futures are used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.
Futures Explained
Futures—also called futures contracts—allow traders to lock in a
price of the underlying asset or commodity. These contracts have
expirations dates and set prices that are known up front. Futures are
identified by their expiration month. For example, a December gold
futures contract expires in December. The term futures tend to represent
the overall market. However, there are many types of futures contracts
available for trading including:
- Commodity futures such as in crude oil, natural gas, corn, and wheat
- Stock index futures such as the S&P 500 Index
- Currency futures including those for the euro and the British pound
- Precious metal futures for gold and silver
- U.S. Treasury futures for bonds and other products
It's important to note the distinction between options and futures. Options contracts give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of the contract.
Pros
- Investors can use futures contracts to speculate on the direction in the price of an underlying asset
- Companies can hedge the price of their raw materials or products they sell to protect from adverse price movements
- Futures contracts may only require a deposit of a fraction of the contract amount with a broker
Cons
- Investors have a risk that they can lose more than the initial margin amount since futures use leverage
- Investing in a futures contract might cause a company that hedged to miss out on favorable price movements
- Margin can be a double-edged sword meaning gains are amplified but so too are losses
Using Futures
The futures markets typically use high leverage.
Leverage means that the trader does not need to put up 100% of the
contract's value amount when entering into a trade. Instead, the broker
would require an initial margin amount,
which consists of a fraction of the total contract value. The amount
held by the broker can vary depending on the size of the contract, the
creditworthiness of the investor, and the broker's terms and conditions.
The exchange where the future trades will determine if the contract is for physical delivery
or if it can be cash settled. A corporation may enter into a physical
delivery contract to lock in—hedge—the price of a commodity they need
for production. However, most futures contracts are from traders who
speculate on the trade. These contracts are closed out or netted—the
difference in the original trade and closing trade price—and are cash settled.
Futures Speculation
A futures contract allows a trader to speculate on the direction of movement of a commodity's price.
If a trader bought a futures contract and the price of the commodity
rose and was trading above the original contract price at expiration,
then they would have a profit. Before expiration, the buy trade—long
position—would be offset or unwound with a sell trade for the same
amount at the current price effectively closing the long position. The
difference between the prices of the two contracts would be cash settled
in the investor's brokerage account, and no physical product will
change hands. However, the trader could also lose if the commodity's
price was lower than the purchase price specified in the futures
contract.
Speculators can also take a short or sell speculative position if
they predict the price of the underlying asset will fall. If the price
does decline, the trader will take an offsetting position to close the
contract. Again, the net difference would be settled at the expiration
of the contract. An investor would realize a gain if the underlying
asset's price was below the contract price and a loss if the current
price was above the contract price.
It's important to note that trading on margin allows for a much
larger position than the amount held by the brokerage account. As a
result, margin investing can amplify gains, but it can also magnify
losses. Imagine a trader who has a $5,000 broker account balance and is
in a trade for a $50,000 position in crude oil. Should the price of oil
move against their trade, they can incur losses that far exceed the
account's $5,000 initial margin amount. In this case, the broker would
make a margin call requiring additional funds be deposited to cover the market losses.
Futures Hedging
Futures can be used to hedge
the price movement of the underlying asset. Here, the goal is to
prevent losses from potentially unfavorable price changes rather than to
speculate. Many companies that enter hedges are using—or in many cases
producing—the underlying asset.
For example, a corn farmer can use futures to lock in a specific
price for selling their corn crop. By doing so, they reduce their risk
and guarantee they will receive the fixed price. If the price of corn
decreased, the company would have a gain on the hedge to offset losses
from selling the corn at the market. With such a gain and loss
offsetting each other, the hedging effectively locks in an acceptable
market price.
1:37
How Do Futures Contracts Work?
Regulation of Futures
The futures markets are regulated by the Commodity Futures Trading Commission
(CFTC). The CFTC is a federal agency created by Congress in 1974 to
ensure the integrity of futures market pricing, including preventing
abusive trading practices, fraud, and regulating brokerage firms engaged
in futures trading.
Choosing a Futures Broker
Investing in futures or any other financial instruments requires a
broker. Stock brokers provide access to the exchanges and markets where
these investments are transacted. The process of choosing a broker and
finding investments that fit your needs can be a confusing process.
While Investopedia can't help readers select investments, we can help you select a broker.
Real World Example of Futures
Let's say a trader wants to speculate on the price of crude oil by
entering into a futures contract in May with the expectation that the
price will be higher by years-end. The December crude oil futures
contract is trading at $50 and the trader locks in the contract.
Since oil is traded in increments of 1,000 barrels, the investor now
has a position worth $50,000 of crude oil (1,000 x $50 = $50,000).
However, the trader will only need to pay a fraction of that amount up
front—the initial margin that they deposit with the broker.
From May to December, the price of oil fluctuates as does the value
of the futures contract. If oil's price gets too volatile, the broker
may ask for additional funds to be deposited into the margin account—a
maintenance margin.
In December, the end date of the contract is approaching, which is on
the third Friday of the month. The price of crude oil has risen to $65,
and the trader sells the original contract to exit the position. The
net difference is cash settled, and they earn $15,000, less any fees and
commissions from the broker ($65 - $50 = $15 x 1000 = $15,000).
However, if the price oil had fallen to $40 instead, the investor
would have lost $10,000 ($40 - $50 = negative $10 x 1000 = negative
$10,000.
:max_bytes(150000):strip_icc()/chart_177418236-5bfc37e1c9e77c002633b5a3.jpg)
:max_bytes(150000):strip_icc()/shutterstock_112522391-5bfc2b9846e0fb0051bde2d3.jpg)
:max_bytes(150000):strip_icc()/active-trading-lrg-2-5bfc2b25c9e77c005143df5f.jpg)
:max_bytes(150000):strip_icc()/low-angle-view-of-skyscrapers-in-tokyo-downtown-682328418-d70e2e1723e94c908a67193b3d93a96b.jpg)
No comments:
Post a Comment