What Are Futures Contracts? Everything You Need to Know
Futures contract is a financial tool that allows those participating in a market to assume, some of the risk that the price of the asset will change over time.3 min read
What are futures contracts is a common question business owners may have. A futures contract is a financial tool that allows those participating in a market to assume, or offset, some of the risk that the price of the asset will change over time. It is how different types of commodities will not only be traded but indexed as well, which provides traders with a wider array of products to trade.
What are Futures Contracts?
The contract is typically made on the trading floor in a futures exchange, and it is a legally binding agreement to sell or buy specific financial instruments or commodities at a set price for a specified time in the future. These contracts are typically standard and were created to facilitate trading on futures exchanges. It will detail not only the price but also the quantity and quality that is being traded.
A futures contract can include the physical delivery of the asset or can include a settlement in cash. When discussing terms, a futures contract will refer to specific characteristics of the asset that will be traded, and the term futures is used as a general term for the market. There are two primary categories in which future contracts can be classified.
Both the purchaser and producer of an asset can hedge or guarantee a price at which the commodity will be sold or purchased in the future. Traders and manager can also make bets on price movements that the underlying asset may have in the future. Futures contracts are currently being traded on numerous stock market indices throughout the world, as well as on major interest rates and major currency pairs.
When it comes to commodities, there is a large number of futures contracts for almost every commodity produced. Some examples of commodities that are often a part of futures contracts are:
- Industrial metals
- Precious metals
- Natural gas
- Energy products
- Carbon credits
Futures contracts can be traded both long-term traders and non-traders who may have an interest in the underlying commodity. You will find futures contracts trade on futures exchanges such as the Chicago Mercantile Exchange and the Intercontinental Exchange.
Your futures contract will include information about the quantity, quality, the physical delivery time, and location. All futures contracts will be centrally cleared, which essentially means that when a futures contract is sold or bought, the exchange becomes the buyer to every seller and the seller to every buyer. This helps to reduce the risk of being associated with the default of either a single buyer or seller.
A futures contract will specify different parameters about the item being traded. You can expect a contract to include:
- The unit of measure
- Whether physical good will be given or a cash settlement
- The quantity of goods that are to be delivered
- The currency in which the contract is established
- Quality factors
How Futures Work and How to Get Started Trading?
In a futures contract, one party will agree to buy a specified quantity of a security or commodity and take the delivery of it on an agreed upon date. The other party to the contract is making the agreement that they will provide it.
Futures markets are used by many types of financial players including investors, speculators, and companies that would like to take physical delivery or supply the commodity. Commodities are a large part of the futures trading world, but it is not all physical commodities such as soybeans and corn, futures trading also includes ETFs, individual stocks, and bonds.
In fact, one of the largest debuts of futures exchanged was when bitcoin debuted. Some traders prefer these types of futures because there is a great leverage potential instead of owning securities directly. A trader can also gain a substantial position without having to put up a large amount of cash. If a trader wants to hedge exposure to the United States stock market they have the option to short-sell a futures contract on the S&P 500. This way if the stock were to fall they would make money on the short, which could balance out their exposure to the index.
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