Key Takeaways
Futures are standardized legal contracts that obligate parties to buy or sell an asset at a predetermined future date and price.
Futures contracts consist of commodity futures, stock index futures, currency futures, etc.
Futures can be used for hedging or speculation.
Understanding futures
Futures contracts (or futures) are standardized legal contracts that obligate the buyer to purchase an asset and the seller to sell an asset at a predetermined future date and price. Contracts are traded at futures exchanges, which act as a marketplace between buyers and sellers.
The predetermined price of the contract is known as the forward price. The specified time in the future when delivery and payment occur is known as the delivery date.
The buyer of a contract is said to be the long position holder and the seller to be the short position holder.
Futures trading typically uses high leverage.
Based on the underlying assets, futures contracts can be classified into different types, including:
Commodity futures such as crude oil, natural gas, corn, and wheat
Stock index futures
Currency futures
Precious metal futures
Using futures
Futures can be used for hedging or speculation.
Futures for hedging
Futures can be used to hedge the price of the raw materials or products you sell to protect against potentially unfavorable price changes.
Let's say an oil producer plans to produce one million barrels of oil over the next year. It is expected to be ready for delivery in 12 months. Assume the current price is $75 per barrel. As oil prices are volatile, the market price at that time could differ greatly from the current price.
If the oil producer thinks oil will be lower in one year, they may opt to lock in a price now, entering into a futures contract. In this way the producer could produce the oil, and then sell it at the current market prices one year after.
Futures for speculation
A futures contract allows a trader to speculate on the direction of a commodity's price movement.
A trader could buy a futures contract if bullish on the underlying asset. If the price does rise and is trading above the original contract price before or at expiration, the buyer could close the long position and realize a profit, and no physical product will change hands.
However, the trader could also lose if the commodity's price is lower than the purchase price specified in the futures contract.
