Futures Contracts: What They Are and How They Work

Futures contracts are agreements to buy or sell something at a specific price on a set date.

Futures contracts allow investors to agree to buy or sell a commodity or financial instrument at a predetermined price at a specified time. They can be valuable tools for mitigating risk, speculating, or capitalising on expected price changes of the underlying asset. In this article, we’ll explore what futures contracts are, how they work, the role of futures exchanges, different types of market participants, and the potential benefits and risks of trading futures.

What Are Futures Contracts?

Futures contracts are agreements to buy or sell something at a specific price on a set date. For example, a wheat farmer could use a futures contract to sell their upcoming crop to a bread company for an agreed price ahead of harvest. This protects the farmer if wheat prices fall unexpectedly and lets the bread company lock in costs.

Futures are standardised contracts that trade on special exchanges so that many traders can buy and sell them easily. The amount one contract covers stays consistent across that commodity, while the price changes based on supply and demand.

How Do Futures Contracts Work? 

When two parties make a futures deal, no money is traded immediately. They’re just securing that future price. These contracts themselves then start trading on the market. Traders can buy and sell futures without dealing in wheat truckloads or oil barrels. As the expiration date gets closer, traders must decide whether to exchange the goods by settling the contracts.

Many speculators buy and sell the contracts to profit from expected price shifts. They close out the contracts and pocket their winnings rather than taking ownership. Commercial users handling the physical products often intend to settle. For example, an airline hedging jet fuel costs would take delivery in those futures.  

The Role of Futures Exchanges

Specialised futures exchanges like the Chicago Mercantile Exchange (CME) host the markets. They standardise terms, facilitate trading, guarantee contracts, and regulate trading. This gives buyers and sellers confidence and pricing transparency. Exchanges introduce futures on all sorts of underlying products - commodities, currencies, bonds, stock indices. This lets all types of traders speculate on prices or manage risks. Modern electronic platforms and clearing houses help exchanges handle huge daily trading volumes. Additionally, zero brokerage account in some platforms like m.Stock by Mirae Asset has made accessing these markets more cost-effective for traders, further democratising participation in futures trading.

The Players in the Futures Market

There are three main roles in the futures game:

1. Commercial Hedgers use futures to minimise pricing risks. Think wheat farmers, gold miners, or airlines offsetting fuel costs.
2. Speculators bet on market ups and downs, providing trading liquidity and volatility.
3. Arbitrageurs exploit small price gaps between assets and futures for low-risk profits. Their trading enforces efficient pricing.

Trading Strategies for Using Futures and Options

When it comes to futures and options trading, people use different tactics to try and profit. Some key trading approaches include:

• Going Long - This means buying a futures contract, hoping that the price will increase before the contract expires. Then, the trader can sell the contract for a higher price and pocket the difference. For example, an investor might buy an oil futures contract now, hoping oil prices rise in the next few months before their contract ends.
• Short Selling - This is the opposite of going long. Short sellers will borrow a futures contract and immediately sell it, hoping the price will drop. Then, they can repurchase it later at a lower price and return the borrowed contract, profiting from the price decrease. For instance, traders might short-sell gold futures if they think gold prices are headed downward.
• Hedging - Hedging with futures means protecting your investments from adverse price swings. For example, a wheat farmer could short-sell wheat futures contracts that mature after their next harvest. If wheat prices fall, their futures trading profits help offset losses on their actual wheat crop.
• Spread Trading - This advanced tactic combines short and long positions on two contracts related to futures. Traders bet that the price difference between the two contracts will change favourably. Spread trading requires a sharp understanding of the markets but offers lower risk than outright long or short positions.

Conclusion

Futures contracts allow parties to trade commodities and financial instruments at fixed prices in the future - serving important price discovery and hedging functions. They are standardised contracts traded on futures exchanges, providing transparency and regulation. While futures offer useful economic utility, the risks should not be underestimated.

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