When traders anticipate gross fluctuations in the market, what do they do? They secure their profit position against price volatility with a contract. It is called a futures contract or futures. Futures are a legal agreement, which authorises the writer and the owner to buy or sell a commodity or stocks at a predecided price and date in the future.
Unlike options, futures are binding contracts, and participating parties are obligated to honour its terms on its expiration date. These are standardised contracts, meaning they ensure quality, quantity and delivery of the physical commodity mentioned in the agreement.
Futures contracts are widely traded in futures exchanges, but it requires some degree of expertise to plan a successful futures trade. We will have detailed discussions on it later. But to begin with, let us understand what a futures contract is.
What Is A Futures Contract?
If you are interested in the finance market and wish to invest in it, then you will often come across the term, futures contract. So, what is a futures contract? As mentioned above, it is a legal contract between two parties who want to secure the position of their underlying asset (stocks, commodities, bonds) against market volatility. But there is more to it.
There are mainly two kinds of futures traders – hedgers and speculators.
Hedgers, as the name suggests, seek protection against future price volatility. They aren’t looking to profit from the deal. Instead, they want to stabilise the price of their product. Profit or loss from the sale is somewhat offset by the price of the underlying commodity in the market.
Speculators, on the other hand, trade against market trends. A speculator may disagree that price will fall in the future, so he will buy a futures contract and sell it to make a profit when price rise. However, this trading needs to take place before the futures expiration date.
By nature, futures trading is a zero-sum game. Since it locks price, it isn’t impacted by the prices in the market at the time of the deal. It offers protection against unpredictable price swings and stabilises the market. Further, its price is settled daily. At the end of a trading day, one’s account is debited, and the other’s gets credited to offset any price change on that day so that no one suffers an unexpected loss.
What Must You Know About Futures Trading?
Profit and loss regarding futures contracts are unlimited. Daily price swing makes these extremely volatile. But still, futures contracts are traded for profit. Most retail traders and portfolio managers are involved in futures trading to leverage advantage.
Let’s consider it with an example.
Suppose crude oil contracts for April are selling at Rs 60 in January. If a trader believes the price of crude oil to go up before April, he can buy the contract for 1,000 barrels of oil at spot price. However, he isn’t required to pay the full cost of Rs 60,000 (Rs 60 x 1000), but only an initial margin, which will cost only a few thousand.
Actual profit or loss will be realised during the final settlement of the contract. If price rises and the seller sells futures contract at Rs 65, he realises a profit Rs 5000 [(Rs 65 – Rs 60) x 1000]. If the price falls to Rs 55, he will earn a loss of Rs 5000 [(Rs 60 – Rs 55) x 1000].
Pros and Cons of Futures
|Investors can speculate with futures price in the direction of the underlying asset price in the market||It involves risks and speculators can lose even their initial margin (because futures use leverage) if price swings the other way|
|Traders use futures contracts to hedge against a price drop in the future market||Investors can lose favourable price advantages by entering a contract if price fall is more than anticipated rate at the time of settlement|
|Investors can save paying upfront by leveraging margin||Using margin also has consequences; investors can end up incurring a huge loss as well|
The commodity futures market is highly volatile, and traders can end up with unlimited profit or loss. It takes skills, knowledge, experience, and risk abilities to trade successfully in the futures market.