Futures Contract Definition

What Is a Futures Contract ?

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a preset price at a specify time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange .

The buyer of a futures narrow is taking on the obligation to buy and receive the fundamental asset when the futures contract expires. The seller of the futures contract is taking on the debt instrument to provide and deliver the underlying asset at the passing go steady.

Key Takeaways

  • Futures contracts are financial derivatives that oblige the buyer to purchase some underlying asset (or the seller to sell that asset) at a predetermined future price and date.
  • A futures contract allows an investor to speculate on the direction of a security, commodity, or financial instrument, either long or short, using leverage.
  • Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.

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How Do Futures Contracts Work?

Understanding Futures Contracts

Futures are derived function fiscal contracts that obligate the parties to transact an asset at a bias future date and price. here, the buyer must purchase or the seller must sell the underlie asset at the fructify price, regardless of the current commercialize price at the termination date .

Underlying assets include physical commodities or other fiscal instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trade on a futures rally. Futures can be used for hedging or craft guess .

” Futures contract ” and “ futures “ refer to the same thing. For example, you might hear person say they bought vegetable oil futures, which means the lapp thing as an oil futures abridge. When person says ” futures contract, ” they ‘re typically referring to a specific type of future, such as oil, gold, bonds, or S & P 500 index futures. Futures contracts are besides one of the most direct ways to invest in oil. The terminus ” futures ” is more general, and is much used to refer to the whole market, such as, ” They’re a futures trader. ”

Futures contracts are standardized, unlike forward contracts. Forwards are alike types of agreements that lock in a future price in the confront, but forwards are traded over-the-counter ( OTC ) and have customizable terms that are arrived at between the counterparties. Futures contracts, on the other handwriting, will each have the same terms regardless of who is the counterparty .

model of Futures Contracts

Futures contracts are used by two categories of market participants : hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased, while portfolio managers and traders may besides make a count on the price movements of an underlying asset using futures .

An petroleum manufacturer needs to sell its oil. They may use futures contracts to do it. This manner they can lock in a price they will sell at, and then deliver the vegetable oil to the buyer when the futures sign expires. similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have anoint coming in each month, they excessively may use futures contracts. This way they know in advance the monetary value they will pay for petroleum ( the futures contract price ) and they know they will be taking manner of speaking of the oil once the sign expires .

Futures are available on many unlike types of assets. There are futures contracts on stock exchange indexes, commodities, and currencies .

Mechanics of a Futures Contract

Imagine an anoint manufacturer plans to produce one million barrels of petroleum over the future class. It will be ready for manner of speaking in 12 months. Assume the stream price is $ 75 per barrel. The producer could produce the oil, and then sell it at the current commercialize prices one year from today .

Given the excitability of anoint prices, the market price at that time could be very unlike than the current price. If the anoint manufacturer thinks oil will be higher in one year, they may opt not to lock in a price nowadays. But, if they think $ 75 is a good price, they could lock in a guarantee sale price by entering into a futures contract .

A numerical model is used to monetary value futures, which takes into bill the stream spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and appliance yields. Assume that the annual oil futures contracts are priced at $ 78 per barrel. By entering into this contract, in one year the manufacturer is obligated to deliver one million barrels of anoint and is guaranteed to receive $ 78 million. The $ 78 price per barrel is received careless of where spot market prices are at the time .

Contracts are standardized. For exemplar, one oil contract on the Chicago Mercantile Exchange ( CME ) is for 1,000 barrels of vegetable oil. consequently, if person wanted to lock in a price ( selling or buying ) on 100,000 barrels of anoint, they would need to buy/sell 100 contracts. To lock in a price on one million barrels of oil/they would need to buy/sell 1,000 contracts.

The futures markets are regulated by the Commodity Futures Trading Commission ( CFTC ). The CFTC is a federal representation created by Congress in 1974 to ensure the integrity of futures market price, including preventing abusive trading practices, fraud, and regulating brokerage firms engaged in futures trade .

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How to Trade Futures Contracts

trade Futures Contracts

retail traders and portfolio managers are not concerned in delivering or receiving the underlie asset. A retail trader has little need to receive 1,000 barrels of petroleum, but they may be interested in capturing a profit on the price moves of oil .

Futures contracts can be traded strictly for net income, angstrom long as the trade is closed before passing. many futures contracts expire on the third Friday of the month, but contracts do vary so check the contract specifications of any and all contracts before trading them .

For example, it is January, and April contracts are trading at $ 55. If a trader believes that the price of vegetable oil will rise before the contract expires in April, they could buy the condense at $ 55. This gives them control of 1,000 barrels of oil. They are not required to pay $ 55,000 ( $ 55 x 1,000 barrels ) for this privilege, though. Rather, the broke only requires an initial margin requital, typically of a few thousand dollars for each compress .

The profit or passing of the status fluctuates in the report as the monetary value of the futures contract moves. If the personnel casualty gets besides boastfully, the broke will ask the trader to deposit more money to cover the passing. This is called sustenance margin .

The final profit or loss of the trade is realized when the trade is closed. In this font, if the buyer sells the abridge at $ 60, they make $ 5,000 [ ( $ 60- $ 55 ) x 1,000 ). alternatively, if the price drops to $ 50 and they close out the position there, they lose $ 5,000 .

Why Is It Called a Futures Contract?

A futures contract gets its name from the fact that the buyer and seller of the contract are agreeing to a price today for some asset or security that is to be delivered in the future .

Are Futures and Forwards the Same Thing?

These two types of derivatives condense affair in much the same manner, but the main difference is that futures are exchange-traded and have standardized compress specifications. These exchanges are highly regulated and provide crystalline narrow and price data. Forwards, in contrast, trade over the counter ( OTC ) with terms and compress specifications customized by the two parties involved .

What Happens If a Futures Contract Is Held Until It Expires?

Unless the abridge placement is closed out prior to its termination, the short-circuit is obligated to make delivery to the long, who is obligated to take it. Depending on the contract, the values exchanged can be settled in cash. Most much, the trader will merely pay or receive a cash settlement depending on whether the underlie asset increased or decreased during the investing holding period. In some cases, however, futures contracts will require forcible rescue. In this scenario, the investor holding the shrink upon passing would be responsible for storing the goods and would need to cover costs for material handling, physical memory, and insurance .

Who Uses Futures Contracts?

Speculators can use futures contracts to bet on the future price of some asset or security. Hedgers use futures to lock in a price today to reduce market uncertainty between now and the time that good is to be delivered or received. Arbitrageurs trade wind futures contracts in or across associate markets, taking advantage of theoretical mispricings that may exist temporarily.

How Can I Trade Futures?

Depending on your agent and your account status with that broke, you may be eligible to trade futures. You will require a margin report and be approved to do indeed. dependent traders in the U.S. will much have the ability to trade futures on different exchanges such as the Chicago Mercantile Exchange ( CME ), ICE Futures U.S. ( Intercontinental Exchange ), and the CBOE Futures Exchange ( CFE ) .

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