Futures Contract: A Comprehensive Guide

Futures contract is a widely utilized financial instrument that entails buying or selling an asset at a pre-agreed price at a future date. It is a standardized agreement between two parties to trade a certain asset or commodity. The term "futures" refers to the contract's expiration date, or the point at which the parties must fulfill their obligations. Investors use futures contracts for both speculation and hedging against price fluctuations. If you're a beginner in the world of trading, this article will help you understand the basics of futures contracts.

How Does It Work?

A futures contract involves two parties: the buyer and the seller. The buyer agrees to buy a particular asset, and the seller agrees to sell it at a future specified date. The contract specifies the details such as the quantity of underlying assets, the pricing method, and the delivery date. When the contract reaches the delivery date or expiration date, both parties must complete the transaction. The buyer takes possession of the underlying asset, and the seller receives the agreed-upon payment.

Why Use Futures Contract?

Futures contracts offer several benefits to traders, such as:

• Hedging: Futures contracts are used to mitigate price risks. For example, if you're a wheat farmer and want to protect against a price drop, you can enter into a futures contract to sell your wheat at a specified future date with a pre-determined price.
• Speculation: Futures contracts also provide opportunities for speculators to invest in a wide variety of underlying assets like commodities, stocks, and currencies.
• Leverage: Investors can trade a significant amount of underlying assets with only a small deposit. This is known as leverage or margin trading.
• Liquidity: Futures contracts are widely traded on various exchanges across the globe, making them highly liquid.

Types of Futures Contracts

Futures contracts are categorized based on the underlying assets being traded:

• Commodity Futures: These contracts involve the buying or selling of physical commodities like crude oil, gold, wheat, coffee, etc.
• Financial Futures: These futures contracts involve financial instruments like stocks, bonds, currencies, or indices such as S&P 500, NASDAQ, etc.

Margin Trading in Futures Contract

Margin trading can magnify profits, but it also magnifies losses. To trade futures contracts, traders are required to keep a certain amount of money, known as a margin, in their trading account. The margin amount varies depending on the contract and the exchange. When you buy a futures contract, you're required to pay the initial margin, which is usually a fraction of the contract's total value. If the contract moves against you, resulting in losses, the exchange will demand additional margin payments to cover the loss. Failure to do so may result in the contract's liquidation or margin calls.

Final Thoughts

Futures contracts offer an excellent way for traders and investors to hedge price risks or speculate on the future price movements of the underlying assets. However, they pose a significant risk if not used carefully. It is essential to understand the contract's details, the underlying asset, and the risks involved. Consider practicing with Demo accounts or Paper trading options before committing your hard-earned cash.