Futures

What is Futures trading?

Futures are a financial contracts between two parties, a buyer and a seller, to purchase or sell an asset at an predetermined future data and price. Unlike stocks, future contracts have an expiration date therefore making market direction and timing are vital.

The main use of future contracts for companies and institutions are to offset their risk exposure and to limit price fluctuations.

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How Does it Work?

Future contracts were initially designed to assist farmers to hedge against price differences of their crops between planting and harvest. However, the trading of futures contracts has advanced from that as traders use future contracts for speculation – this allows for profits by betting on the direction of the asset.

Hedging

The purpose of hedging is not to gain from favourable price movements but prevent losses from potentially unfavourable price changes and in the process, maintain a predetermined financial result as permitted under the current market price.

To hedge, someone is in the business of actually using or producing the underlying asset in a futures contract. When there is a gain from the futures contract, there is always a loss from the spot market, or vice versa. With such a gain and loss offsetting each other, the hedging effectively locks in the acceptable, current market price.

Speculating

Futures contracts are used to manage potential movements in the prices of the underlying assets. If market participants anticipate an increase in the price of an underlying asset in the future, they could potentially gain by purchasing the asset in a futures contract and selling it later at a higher price on the spot market or profiting from the favourable price difference through cash settlement.

However, they could also lose if an asset's price is eventually lower than the purchase price specified in the futures contract. Conversely, if the price of an underlying asset is expected to fall, some may sell the asset in a futures contract and buy it back later at a lower price on the spot.