What is a futures contract?

Definition and Example of Futures Contract

A futures contract is essentially a promise to buy or sell an asset in the future, and traders can buy and sell these promises. The futures contract specifies the price at which the assets will be traded and the time when the trade will occur.

Key points:

  • A futures contract is an agreement to trade an asset at a specific price on a specific day in the future.
  • Futures contracts allow companies to hedge risks and better plan for upcoming quarters.
  • Futures contracts can be written for commodities like oil or financial instruments like stocks, bonds, and currencies.

How Does a Futures Contract Work?

Futures contracts are traded on public exchanges, such as the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), and the New York Mercantile Exchange (NYMEX), all of which are owned by the CME Group.

The role of the futures exchange is similar to that of a stock exchange. Exchanges provide a safe and efficient place to trade futures contracts. The contracts are processed through the exchange’s clearinghouse. Technically, the clearinghouse buys and sells all contracts.

A single futures contract must be very specific. It must be for the same asset, the same quantity, and the same quality. It must also be for the same delivery month and the same location.

How Do Futures Contracts Affect the Economy?

Futures contracts help companies secure prices, which benefits both buyers and sellers. A transportation company, for example, can use futures contracts to lock in a guaranteed price for gasoline. This allows the transportation company to plan for the future more accurately by relying on market prices for fuel.

Similarly, farmers use futures contracts to secure a selling price for their livestock or crops. They can also plan how (and where) the goods will be transported under the contract. Just like a transportation company buying futures contracts for gasoline, farmers selling futures contracts for commodities can accurately plan future revenues and costs without worrying about changing consumer demand and other factors.

Futures contracts allow economists to make price assessments and forecasts for commodities. These values are partially determined by traders who trade futures contracts and also by analysts monitoring these markets.

Hedge funds use futures contracts to gain more leverage in the commodities market. They do not intend to actually buy, sell, or interact with any commodity. Instead, they plan to buy a counter contract at a price that will enable them to make a profit. In a way, they are betting on the expected future price of that commodity.

Types of Futures Contracts

Futures contracts are written for commodities, stocks, bonds, and currencies.

Commodities:

Commodities are physical assets like wheat, gold, and oil. Among these commodities, oil futures may be the most important, as they set the prices for oil. Oil prices, in turn, are the main factor in the price you pay at the fuel station. When oil prices rise, the station prices will also rise.

Stocks and Bonds:

Traders can trade futures contracts for financial instruments when they sense a change in economic trends. If they believe prices will decline, for example, they might buy a futures contract for bonds (because bond prices rise when interest rates fall). If a trader believes stocks will rise, they might buy futures contracts corresponding to the S&P 500 index.

Currencies:

Futures contracts for currencies are written in pairs. They are a promise to exchange a certain amount of one currency for a certain amount of another currency. For example, if a trader believes that the value of the US dollar will rise relative to the euro, they will buy a futures contract for USD/EUR that reflects their belief.

Traders can also trade options on futures contracts. Futures options give the buyer the right (but not the obligation) to buy or sell a futures contract by a certain date. Futures options cost less than buying an actual futures contract. They can reduce risk (if used wisely) and also allow more traders to achieve greater diversification.

Contract

Futures vs. Forward Contracts

Futures Contracts:

  • Traded on an exchange.
  • Standardized.
  • Relatively safer than forward contracts.

Forward Contracts:

  • Traded over-the-counter (OTC).
  • Private and customizable.
  • Relatively riskier than futures contracts.

Futures contracts are similar to forward contracts, but there are some key differences that are important to understand. The simplest way to think of the differences is that a forward contract is a more customized form of a futures contract. The delivery time and purchase price of a forward contract are tailored to meet the specific needs of the buyer and the seller.

This level of customization comes with some downsides. Exchanges only allow the trading of standardized contracts. Because forward contracts are customized, they are traded outside of standardized exchanges, or “over-the-counter” (OTC). Because they are not traded on an exchange, there is less regulation with forward contracts, carrying higher risks than futures contracts.

Source: https://www.thebalancemoney.com/what-is-a-futures-contract-3305930

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