IronFX explains the finer details of futures contracts
A quick guide to understanding futures contracts.
Buying or selling goods and services in a cash market is something quite comfortable for anyone. However, when it comes to the workings of future contracts, many people have difficulty fully understanding them.
Despite the apparent barrier to understanding these markets, the logic of a futures contract is quite simple: it is a commitment to buy or sell an asset at a specific date in the future, at a price previously established. It is important to note that the investor may sell a contract that he has bought before the due date.
In other words, a futures contract is a legal agreement between two parties which involves buying or selling assets or commodities at a specific time in the future, explains IronFX. Types of futures include oil, silver, bonds, and the Nasdaq 100 Index – commodities, stocks, indices, and currencies.
More about the contracts
These contracts are traded on a futures exchange and the buyer will buy the underlying asset at a predetermined price when the contract expires, while the seller of the contract will sell the underlying asset at the expiration date.
The key players in the futures market are hedgers, who are producing or purchasing an underlying asset and hedging to secure or guarantee its future price at which it will be sold or bought to minimise risk, and speculators – also known as traders or portfolio managers. They will bet on the underlying asset’s price movements and hope to profit from any price changes.
To better understand how this actually works, here is an example of hedging: an oil producer aims to produce and sell one million oil barrels in a year’s time. Each barrel is priced at $75, and the producer could sell the oil at this current price in one year’s time. Bear in mind that oil prices are volatile – in 12 months, the market price could be very different.
The producer might not lock in this price now if they think oil market prices will be higher in a year. The producer can lock in this price now and enter a futures contract if he/she believes $75 is a reasonable price. When entering into this contract, the producer is required to sell one million oil barrels and will receive $75 million. The producer will have no choice but to sell at $75 per barrel irrespective of where market prices stand at the time.
How speculating really works
Now, to understand how speculating works, here is another example: it is February, and May contracts are trading at $65. If the trader believes that the oil price will increase before May, they will buy the contract at $65. For 1000 oil barrels, the trader will not have to pay $65,000 ($65 x 1,000 barrels). Instead, there would be an initial margin payment to the broker, which is usually a few thousand dollars per contract.
There will be fluctuations in the profit or loss as the price changes. Sometimes, the loss is substantial, and the broker will intervene and tell the trader to deposit more funds (to cover losses) – aka maintenance margin. The trade will close at the time of expiration, and the profit or loss will be realised. In the case of a profit – the buyer may sell the contract at $70, giving them $5,000 [($70-$65) x 1000). If the price drops to $60, and the position is closed, they will incur a $5,000 loss.
With this in mind, it is easy to understand that this is an appealing market. It can help a country’s economy, as it enables entrepreneurs to add a degree of certainty to their future operations. It pays off for investors and traders, who find a way to diversify their investments.
This type of contracts will soon suffer a great technological evolution, which will be surely interesting to follow.
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