Futures are a type of financial contract commonly used to hedge an investment or speculate on market prices.
Through clever use of these financial tools, it’s possible to minimize the risk of loss from unfavorable changes in the market, while capitalizing on potential gains.
As with all forms of trading opportunities, it’s important to understand how futures work to ensure the best chance of making wise financial decisions.
Futures, otherwise known as futures contracts, are financial contracts that obligate buyers and sellers to complete transactions to purchase assets at set prices in the future.
Assets traded through futures contracts include physical commodities and financial instruments, including:
- Stocks and bonds.
- Foreign currencies.
- Precious metals.
- Oil and natural gas.
Options vs. futures
An option is a type of financial contract that grants someone the right, but not the obligation, to complete a transaction for a security or financial asset at an agreed price on or by a specific date.
A call option grants the opportunity to buy an asset at a certain price, while a put option grants the opportunity to sell at a certain price.
The main difference between options and futures is that options grant the right to complete the terms of the agreement if you want, while futures are a legally binding obligation to complete the terms of the agreement. Options and futures are useful tools for hedging and speculating in different situations.
Examples of futures trading
Futures traders fall into two main categories: hedgers and speculators. In many cases, these traders never sell or receive the underlying asset of a futures contract, as they are only interested in hedging and speculating on the asset’s price.
Hedging. Hedging is a way of minimizing potential loss, arising from unfavorable changes in market prices. Futures are useful to this end, as it’s possible to fix a sale price on a commodity to maintain a specific financial outcome.
Hedging is important as it allows companies to stabilize their prices and financial performance. The companies set their prices in advance, smooth out cash flows and making it easier to plan for the future.
Speculating. Speculating involves analyzing market prices and making informed “bets” on how prices are going to change.
For example, if you evaluate the market for corn and determine that prices are going to rise considerably, you can buy a futures contract in corn, locking in the lower price. If the price then increases, you can make a profit by selling the futures contract for a higher sum before it expires. In this way, you make a profit on the contract without ever having to purchase the corn.
Speculating is a risky strategy. If you make the wrong call, prices could swing in the opposite direction of your prediction. For example, if you lock in a price with a futures contract, but the commodity is actually cheaper than that price when the contract expires, you still are obligated to pay the higher amount.
Futures traders operate through futures exchanges such as The New York Mercantile Exchange and the Chicago Board of Trade. All exchanges involve clearing members, which is normally a large bank or financial services company.
The clearing member guarantees each trade by taking deposits from the traders and ensuring nobody defaults on a contract.
Furthermore, all futures contracts follow a standardized format so commodities are comparable, and traders know exactly what they are getting in a transaction. The Commodity Futures Trading Commission monitors all trading activity, reducing the risk of abusive trading and fraud.
READ MORE: Does the futures market predict the future?