What Are Futures Contracts?
Futures contract is a standardized legal agreement to buy or sell an asset in a set predetermined price at a given date some time in the future. These contracts are traded on regulated exchanges like the Chicago Mercantile Exchange (CME), and they encompass a very wide range of underlying assets, comprising:
- Commodities: This includes gold, oil, wheat, natural gas, etc.
- Financial instruments: These comprise stock indices, government bonds, currencies, etc.
- Emererging asset: This includes cryptocurrencies such as Bitcoin and Ethereum.
Each of these contracts has a specified quantity of the asset and sometimes has to include some quality to physically obtainable goods, price, and time of expiration. Thus, all parties will be aware of their obligations and value under the contract.
Key Features of Futures Contracts
- Standardization: Futures, like stocks, are standardized so that they may be tradable. For example, the fixed amount of the asset and the predetermined dates of delivery for that asset are also part of the quality specifications.
- Leverage: Futures allow participants to control a large position with a relatively small initial investment, called a margin. Such profit-maximizing can be realized as well as distorted risks.
- The mark to market: the gain or loss will be computed and settled every end of trading day against market price. Thus, ensuring transparency and consequently reducing counterparty risk.
- Physical delivery takes place if the actual asset gets exchanged after the expiry of the contract.
- Cash settlement takes place when there is no physical delivery, and the difference between the price on the contract and the market price is settled in cash.
- How Futures Markets Operate
- A market for trading futures is where orders for buying and selling future deliveries of specific goods and traded futures are matched with one another through centralized exchanges. Generally, the participants of the futures market can be categorized into two:
- Hedgers: Hedgers use futures contracts to mitigate risks. For example:
- A wheat farmer may sell wheat futures to lock in the price at which his crop will be sold.
Advantages of Futures Contracts
- Transparency of price: Futures pricing is quite transparent and is done instantaneously depending on the position of supply and demand.
- Liquid: Future contract markets with huge volume of trades ensure that participants easily enter or exit their positions with little impact on prices.
- Efficiency of Cost: These agreements usually have low transaction costs relative to those of other financial instruments.
- Hedging against inflation: Commodities have futures, mainly not ignoring their historical inflationary propensity of prices.
- Risks with Futures Contracts
- Risk of leverage: Leverage increases the profits earned but also significant losses in circumstances when the market turns sour to a trader’s position.
- Market Volatility: Sharp inclination in price movement may occur within futures markets making them risky to inexperienced traders.
- Expiration Risk: Futures comic books have a specific expiration date within which a trader has to either close or roll over his positions, which may incur additional costs as well.
- Counterparty Risk: Even though the scope to minimize this by virtue of trading on regulated exchanges is tangible, defaults would still remain a consideration in extreme market conditions.
Examples of Common Futures Contracts
- Crude Oil Future: These futures are heavily traded as they allow energy companies and speculators to hedge against bioscience price risks.
- S & P 500 futures: These contracts track the S & P 500 index performance reflecting its movements to provide exposure to the U. S. stock market.
- Gold futures: Gold futures constitute a kind of investment futures for those risk-averse investors who might be concerned with an economic downturn.
- Bitcoin Futures: With increased acceptance of cryptocurrencies, Bitcoin futures have been an important instrument in managing volatility by keeping all the players in line.
The Current Trends in Futures Markets
- Integration with Technology: AI is incorporated into trend analysis and trading strategy optimization using machine learning.
- The cryptocurrency futures: The exponential growth of digital assets keeps increasing the attention of people towards cryptocurrency futures.
- Future for Sustainability: These did make a bit of progress in futures based on carbon credits and renewable energy.
- Regulatory Developments: The works are on by government and exchanges towards the better-control of fair and secure futures markets.