Futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a specific date in the future. Unlike spot transactions, where the exchange of assets and payment occurs immediately, futures contracts involve a delayed delivery and payment. These contracts are traded on futures exchanges, providing a regulated marketplace for price discovery and risk management.
How Futures Contracts Work
When you buy a futures contract, you are obligated to purchase the underlying asset at the agreed-upon price on the delivery date. Conversely, if you sell a futures contract, you are obligated to deliver the asset at that price. Futures contracts are marked-to-market daily, meaning profits and losses are calculated and settled each day based on the contract’s current market value. This daily settlement process helps to mitigate counterparty risk.
Uses of Futures Contracts
- Hedging: Businesses use futures contracts to protect themselves against price volatility. For example, a farmer can sell futures contracts for their crops, locking in a price and reducing the risk of price declines before harvest. A manufacturer can buy futures contracts for raw materials, protecting against price increases.
- Speculation: Traders can speculate on the future direction of prices by buying or selling futures contracts. If they believe the price of an asset will rise, they can buy futures contracts. If they expect the price to fall, they can sell futures contracts.
- Price Discovery: The trading activity on futures exchanges helps to establish future prices for the underlying assets. This price discovery mechanism is valuable for businesses and consumers.
Risks of Futures Trading
Futures trading involves leverage, meaning a small price movement can result in a large profit or loss. This leverage amplifies both gains and losses, making futures trading risky for inexperienced investors. It is crucial to understand the risks involved before trading futures contracts.
Conclusion
Futures contracts are powerful financial instruments used for hedging, speculation, and price discovery. They provide a way to manage risk and participate in the price movements of a wide range of assets.