A futures contract is a legal agreement to buy or sell a particular commodity, asset or security at a predetermined price at a specified time in the future. The buyer of the futures contract is obligated to buy the underlying asset when the contract expires. And the seller is obligated to provide and deliver the underlying asset on expiry. Unlike forward contracts, futures are regulated and standardized to allow trading on a futures exchange.
Using Futures To Hedge
Futures are often used to lock in the price of a commodity to hedge against market volatility. For example, a manufacturer may need 1,000 barrels of oil in three months, by entering a futures contract with the oil producer for $50 a barrel, the oil producer is guaranteed $50,000 and the manufacturer is guaranteed a price of $50 per barrel for 1,000 barrels. This protects the producer from the risk of oil prices dropping and the manufacturer from the risk of oil prices rising.
Speculators use futures to profit off the change in price of the underlying asset. For Example, a speculator who believes the price of oil will rise in the next three months may buy futures at $55 and then sell the contract at $60, when the price of oil goes up, making $5 a barrel. It is important to note that if the buyer purchased futures for 1,000 barrels, they would not need to spend $55,000. They would just need to put enough money in the account to fulfil the minimum margin requirements. The value of the futures contract will fluctuate in their account until they close the position. Also, if the loss gets too big, their broker may ask for additional capital to satisfy the margin requirements.
Things To Consider
If you hold until expiry, you are obliged to exercise the contract – This means the short is obligated to make the delivery to the long and the long is obligated to take it. In most cases this will be settled in cash, where the trader simply pays or receives a cash amount depending on whether the price of the underlying asset increased or decreased.
Physical Delivery – In some cases upon contract expiry future contracts will require physical delivery. In this scenario the trader holding the contract will be responsible for storing the goods and would need to cover the costs for material handling, physical storage and insurance.
How to trade futures – To trade futures you need to open an account with a broker. You will need a margin account and be approved as eligible to trade them.