What is a Futures Contract?
A futures contract is a financial contract where two parties agree to buy and sell a set of financial instruments at a particular price for future delivery. When buying into a futures contract you are essentially agreeing to purchase something at a set price that a seller has not yet produced. Most buyers and sellers in the futures market enter into a contract to speculate or hedge risk rather than exchange physical goods. For this reason, futures are used by producers, consumers and speculators as financial instruments.
How the Futures Market Works
The futures market is a centralized marketplace. Buyers and sellers from across the globe meet and enter into futures contracts. Bids and offers can either be matched electronically or based on an open outcry system. The futures contract stipulates the date of delivery and how much will be paid.
All futures contracts specify information such as the quality and quantity of the commodity as well as the specific price per unit. The date and method of delivery are also included. The contract’s price is represented by a previously agreed upon price of the underlying financial instrument or commodity that will be delivered in the future.
Importance of the Futures Market on the Economy
The futures market is an ideal resource for vital market information. It is central to the global marketplace and highly active. It is an incredibly competitive market that plays an important economic role in determining price movements based on current and future estimated amounts of supply and demand.
Future market prices require high levels of transparency as they depend on the constant flow of information from across the globe. Factors such as the environment, war, refugee displacement, debt default and deforestation can all have a significant impact on supply and demand, and on the current and future price of a commodity. This type of information and the way it is absorbed continually changes the prices of commodities. This is a method known as ‘price discovery’.
Risks are reduced in the futures market because the price of futures contracts is pre-determined, thus letting investors know how much they need in order to buy or sell. With reduced risk there is less chance that manufacturers will increase prices to make up for loss of profit in the cash market, which in turn helps to reduce the ultimate cost to the retail buyer.
Futures Trading Strategies
Basically, futures contracts try to predict a future price of a commodity or an index. Different strategies are used by speculators to benefit from rising and falling prices. The most common strategies are outlined below:
Going Long: When going long an investor tries to profit from an anticipated price increase. This is achieved by entering in to a contract and agreeing to buy and receive delivery of the underlying asset at a specific price.
Going Short: Going short involves entering into a contract and agreeing to sell the underlying asset at a set price. This is achieved by attempting to make a profit from declining price levels.
Spreads: Futures spread involves benefiting from the difference in price between two different contracts of the same financial instrument or commodity. Spreading is a more conservative approach to futures trading as it is considered far safer than going long or going short.
Buying and selling futures contracts can seem complicated and risky; therefore, futures trading is not for every person. However, it works for a wide range of market participants, offering them yet another avenue for diversifying their investment portfolios.
Although there are many different strategies that you can use when trading futures, it is important that you thoroughly research the futures market and understand how futures work. The more knowledge and information you have, the easier it will be to decide if futures trading is right for you.