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

FAQs

Futures Contract: Meaning, Definition, Pros & Cons | 5paisa? ›

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.

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. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.

Companies engaged in foreign trade use futures to manage foreign exchange risk, interest rate risk by locking in an interest rate in anticipation of a drop in rates if they have a sizable investment to make, and price risk to lock in prices of commodities such as oil, crops, and metals that serve as inputs.

Risks associated with futures contract

Margin call risk: If the market moves against your position, you may be required to deposit additional margin to cover potential losses. Failure to meet margin calls can lead to forced liquidation of your position. Expiration risk: Futures contracts have fixed expiration dates.

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.

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.

A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month.

Futures do not suffer from time decay, which is a crucial advantage over options. Time decay erodes the value of options as they approach their expiration date. Futures prices, however, are not affected by this phenomenon.

If a trader has not offset or rolled his position prior to contract expiration, the contract will expire and the trader will go to settlement. At this point, a trader with a short position will be obligated to deliver the underlying asset under the terms of the original contract.

Why buy futures instead of stocks? ›

1. Fruitful Investment. Futures may not be the best way to trade stocks, for instance, but they are a great way to trade specific investments such as commodities, currencies, and indexes. Their standardized features and very high levels of leverage make them particularly useful for the risk-tolerant retail investor.

Settlement type: Futures contracts can be settled through physical delivery of the underlying asset or cash settlement. For crude oil futures like “CLZ24,” physical delivery is more standard, though many participants close their positions before the delivery date to avoid actual delivery.

Futures contracts are products created by regulated exchanges. Therefore, the exchange is responsible for standardizing the specifications of each contract.

There are two sides to every future or forward contract, a long and a short. The long is the purchaser of the contract, and profits as the underlying asset increases in value. The short is the seller of the contract, and profits as the underlying asset decreases in value.

Failure: An Insufficient Commercial Need

Some new contracts historically have failed because there was an insufficient need for commercial hedging. This occurred when economic risks were not sufficiently material or contracts already provided sufficient risk reduction.

The amount you may lose is potentially unlimited and can exceed the amount you originally deposit with your broker. This is because futures trading is highly leveraged, with a relatively small amount of money used to establish a position in assets having a much greater value.

A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Typically, futures contracts are traded electronically on exchanges such as the CME Group, the largest futures exchange in the United States.

Futures trading is a financial strategy that allows you to buy or sell a specific asset at a predetermined price at a specified time in the future. It's a way to potentially profit from the price movements of commodities, stocks, and other assets.

Futures contracts expire; shares of stock don't

A futures contract, in contrast, has a fixed life. A crude oil June 2023 futures contract, for example, expires on a certain date based on the contract specifications.

Futures contract trading example

Say it's April and you think the price of oil is going to rise in the future – you could open a long spread bet or CFD on a June oil future. Your profit is determined by how much the price of oil has risen by the future's expiry, and the size of your position – less any charges.