Futures Contract: Meaning, Definition, Pros & Cons | 5paisa (2024)

FAQs

What are the pros and cons of futures contracts? ›

Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.

Definition: A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future. Description: The payment and delivery of the asset is made on the future date termed as delivery date.

Futures contracts are traded between two parties, and the buyer agrees to buy a specific amount of product from the seller at an agreed-upon price at a future date. Futures quotes include the open price, high and low, the closing price, trading volume, and ticker.

A futures contract allows an investor to speculate on the direction of a security, commodity, or financial instrument, either long or short, using leverage. Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.

Advantages of futures trading include access to leverage and hedging while disadvantages include overleveraging and challenges presented by expiry dates. Choose a futures trading platform that is intuitive, offers multiple order types, and has competitive fees and commissions.

An example of a future is when an oil buyer strikes a deal with a seller to buy oil at a fixed price in a year, anticipating a price hike following a decline in mining activities. The buyer agrees to purchase fixed oil units at a price regardless of price fluctuations at the end of the year.

Narrator: One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change.

Low Execution Cost

To own a futures contract, an investor only has to put up a small fraction of the value of the contract (usually around 10%) as margin. The margin required to hold a futures contract is therefore small and if he has predicted the market movement correctly, he receives huge profits.

CME Group's Micro E-mini futures contracts expire on a quarterly basis, settling to the official opening level of their respective index on the third Friday of March, June, September and December. Prior to expiration, a futures trader has three options: Offset the position to fully close out the trade.

The different types of futures contracts include equity futures, index futures, commodity futures, currency futures, interest rate futures, VIX futures, etc.

What are the risks of futures contracts? ›

Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.

Futures have several advantages over options in the sense that they are often easier to understand and value, have greater margin use, and are often more liquid. Still, futures are themselves more complex than the underlying assets that they track.

As an investment tool, futures contracts offer the advantage of price speculation and risk mitigation against potential market downturns. However, they come with some drawbacks. Taking a contrary position when hedging could lead to additional losses if market predictions are off.

Futures look into the future to "lock in" a future price or try to predict where something will be in the future; hence the name. Since there are futures on the indexes (S&P 500, Dow 30, NASDAQ 100, Russell 2000) that trade virtually 24 hours a day, we can watch the index futures to get a feel for market direction.

A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.

It's also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price.

What futures are most profitable? Trading in futures markets such as the Micro E-Mini Russell 2000 (M2K), Micro E-Mini S&P 500 (MES), Micro E-Mini Dow (MYM), and Micro E-Micro FX contracts can be highly profitable due to their distinct market characteristics.

Options are generally considered safer than futures because the potential loss in options trading is limited to the premium paid, whereas futures carry higher risk due to potential unlimited losses resulting from leverage and market movements.

Lack of a clear strategy: Futures and options trading requires a well-defined strategy. If investors do not have a clear plan, exit strategy, or risk management, they may make impulsive decisions that lead to losses.

Futures are financial contracts obligating the buyer to purchase, and the seller to sell, an asset at a predetermined future date and price.

Who pays in a future contract? ›

The buyer or seller of a futures contract is required to deposit part of the total value of the specified commodity future that is bought or sold – this is known as margin money.

Futures contract example

For example, Crude Oil is currently selling at $60 a barrel, and a futures contract for $65 per barrel is available for three months' time. As you believe the price of WTI will rise beyond $65 by the time of expiry, you buy the contract. The market actually rises to $75.

Futures have several advantages over options in the sense that they are often easier to understand and value, have greater margin use, and are often more liquid. Still, futures are themselves more complex than the underlying assets that they track. Be sure to understand all risks involved before trading futures.

A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract. There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC).