Future contracts, sometimes referred to as futures, are a type of financial instrument that allows traders to buy or sell an underlying asset at a predetermined price and date in the future. This type of contract is commonly used by investors to speculate on the future price of a commodity, currency, or stock index. In this article, we will delve into the world of future contracts and explore their importance in the financial market.

What is a Future Contract?

A future contract is a binding agreement between two parties, who agree to buy or sell an underlying asset at a specified price on a future date. The asset could be a commodity like gold, oil, or wheat, a physical asset like real estate, or a financial asset, like bonds, currencies, or stocks. The date when the delivery of the underlying asset takes place is referred to as the settlement date.

The two parties involved in the contract are the buyer and the seller. The buyer of the future contract is taking a long position, which means they are agreeing to buy the asset at the agreed-upon price when the contract expires. The seller of the future contract is taking a short position, which means they are agreeing to sell the asset at the agreed-upon price when the contract expires.

Why are Future Contracts Important?

Future contracts play a significant role in the financial market as they provide a way for traders to hedge against the risk of price fluctuations. For example, if a farmer is concerned that the price of wheat will fall during harvest time, they could sell future contracts in wheat to lock in the current market price. This would eliminate the risk of a price drop during harvest time, ensuring that they get a fair price for their crop.

Moreover, futures can also be used for speculation purposes. Traders can buy or sell future contracts in the hope of profiting from price movements. For example, if a trader believes that the price of gold will rise in the future, they would buy a gold future contract. If the price of gold does rise, the trader can sell their contract at a higher price and make a profit. Conversely, if the price of gold falls, the trader would lose money.

How Do Future Contracts Work?

Future contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). These exchanges act as intermediaries between buyers and sellers, ensuring that contracts are settled fairly and objectively.

To trade a future contract, a trader must open a margin account with a broker. The margin account is a deposit that ensures that the trader has enough funds to cover any losses they may incur. When a trader buys a future contract, they pay a percentage of the total value of the contract as a margin deposit. This amount is typically around 5-10% of the total contract value.

When the contract expires, the buyer of the contract must take delivery of the underlying asset, or they can roll the contract over by buying a new contract with a later settlement date. Alternatively, they can sell their contract to another party before the settlement date.

Conclusion

Overall, future contracts are an important tool in the financial market, providing traders with a way to hedge against risk and speculate on price movements. It is essential to understand how these contracts work and the risks associated with trading them. By doing so, traders can make informed decisions about whether future contracts are right for their investment strategy.