What Is a Futures Contract?

Futures Contract is a financial agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. Futures contracts are commonly used in trading commodities, currencies, and financial instruments, allowing traders to hedge against price fluctuations or speculate on future price movements.

How It Works

• Standardized Agreements: Futures contracts are standardized, meaning they specify the quantity and quality of the underlying asset, as well as the expiration date. This standardization allows for easy trading on exchanges.
• Leverage: Traders can control a large position with a relatively small amount of capital due to leverage. For example, if a futures contract requires a margin of 10%, a trader can control $10,000 worth of an asset by only putting down $1,000.
• Settlement: At expiration, futures contracts can be settled in two ways:
• Physical Settlement: The actual asset is delivered (e.g., barrels of oil or bushels of wheat).
• Cash Settlement: The difference between the contract price and the market price at expiration is paid in cash, meaning no physical delivery occurs.
• Hedging and Speculation: Traders use futures contracts for different purposes. Hedgers protect against price fluctuations (like farmers locking in prices for their crops), while speculators aim to profit from changes in asset prices.

Example

Suppose a trader believes that the price of gold will rise in the next three months. They could enter into a futures contract to buy gold at $1,800 per ounce, with the contract set to expire in three months. If the price of gold rises to $1,900 at expiration, the trader can buy at the lower price of $1,800 and sell at the market price of $1,900, realizing a profit. Conversely, if the price drops to $1,700, the trader faces a loss.

Now, imagine another trader believes that the price of gold will fall in the next three months. They could enter into a futures contract to sell gold at $1,800 per ounce. If the price of gold does drop to $1,700 at expiration, the trader can sell at the contract price of $1,800 while buying it back at the lower market price of $1,700, making a profit of $100 per ounce. However, if the price unexpectedly rises to $1,900, the trader will incur a loss, as they will have to sell at the agreed-upon price of $1,800 while the market price is higher.

Key Takeaways

• A Futures Contract is a financial agreement to buy or sell an asset at a predetermined price on a future date, allowing traders to hedge or speculate.
• Futures contracts are standardized and traded on exchanges, enabling easy transferability and liquidity.
• They involve leverage, allowing traders to control larger positions with less capital but also carrying the risk of significant losses.
• Settlement can occur through physical delivery of the asset or cash settlement based on the price difference.

In short, a futures contract is like a promise to buy or sell something later at a specific price, allowing traders to plan for the future and manage risks related to price changes.