In a world filled with uncertainties, making a solid, fail-proof plan is like adding HVAC systems to your home in the summer to maintain warmth during the winter— this is what futures is all about.
Futures are agreements between buyers and sellers to sell/buy a commodity at a particular price at a future date/time. This concept is widely used in many industries like agriculture, oil and gas, finance, etc., and is used as a hedging strategy or for speculation purposes.
Understanding futures is highly essential, as it is widely used, especially in the financial markets. We have dissected the crucial bits of futures for easy understanding, so keep reading to learn more.
What Are Futures?
Futures are a type of derivative contract that allows you to buy or sell an asset or commodity at a future date for a specific price.
A derivative is a set of explicit financial contracts that state how parties will respond to future changes in the market value of an underlying asset and are set based on the asset’s value. Futures and options are two popular types of derivatives, and the major difference between them is that in futures, the contract holder is obligated to settle the contract upon expiration. In contrast, the contract holder is not obliged to settle the contract upon expiration in an options contract.
Futures contracts are typically carried out on approved exchanges by buyers and sellers with approved brokerage accounts. You can either buy or sell a futures contract. If you’re buying, you will pay the agreed amount on the contract expiration date for the asset. If you’re selling, you’ll deliver the agreed asset on the contract expiration date at the agreed price.
Futures are helpful because investors and businesses can use them for hedging and speculation. For example, if a flour mill wants to hedge against inflation, they can draft a futures agreement with a wheat grain supplier to buy 500 tons of wheat at a specific price in five to ten years. By doing this, the flour mill hedges against inflation. Thus, if the price changes due to inflation and other market swings, they’re secure knowing they can still get the commodity at that price. On the flip side, if the price reduces far more than what is locked in, they won’t enjoy the benefits of buying it cheaper.
Also, investors can profit by using futures to speculate price movements. Speculators analyze and forecast price movements, then trade contracts to make profits. They make profits by buying futures contracts and selling them at higher than the original price or selling contracts and buying back at a lower price than they bought. Either way, profit is made.
Uses For Futures
As explained above, futures are used for two sole purposes in trading; hedging and speculation. We’ll explicitly explain how futures are utilized for these two purposes.
Futures for Hedging
Producers and large consumers of an underlying asset use futures to hedge the prices of their commodities. This is done to avoid risks that come with unpredicted market movements, thus being a safe landing. It also ensures that they have a buyer for their commodity, no matter what happens in the market.
As explained in the example above, a flour mill company will benefit from a futures contract because it will help them plan their operations budget, knowing that unforeseen price movements and inflation will not affect it. Subsequently, the wheat grain farmer is also insured, as he knows he has a buyer, no matter what.
The only disadvantage to this arrangement is that the buyer might miss out on buying at lower prices should the market take a plunge, and the seller will miss out on selling at higher prices if there is an inflation in prices. Other than that, this arrangement is safe and beneficial for both parties. Note that using futures as a hedging strategy isn’t used for just physical commodities. It can also be used for stocks and cryptocurrencies.
Futures for Speculation
Price movements are usually predictable for the most part, except for a few unforeseen circumstances. Investors with a high level of knowledge in price analysis might predict a price movement and want to lock in on it to earn profits. They can trade the futures of that commodity, even if they don’t have a direct interest in it. For example, if an investor predicts that Bitcoin is on the rise, they might buy Bitcoin futures and resell them, even if they don’t have a direct interest in it. This way, they can profit from it and move on to the next.
Examples of Futures
Anyone can use futures in any industry and for any asset or commodity as long as there’s a high number of consumers.
Some of the most popularly traded futures are:
- Energy futures— Used by energy companies to give insight into prices of everyday energy products like ethanol, crude oil, etc.
- Agricultural futures— These were the first set of futures contracts available in exchange markets, and they provide insights into prices of different agricultural produce like cattle, corn, wheat, cotton, etc.
- Currency futures— These contracts give insight into the exchange rates of different fiat and cryptocurrencies like Bitcoin, United States Dollars, Ethereum, Euro, etc.
- Financial futures— There are two classes of financial futures contracts; index contracts and interest rate (debt). Index contracts expose specific market index values like S&P 500 and Dow Jones, while interest rates give insights into the interest rate of a particular instrument like Treasury bonds.
- Metal futures— These are used to provide insight into prices of in-demand metals like gold, platinum, steel, etc.
Why Trade Futures?
Many investors and traders find futures pretty valuable for hedging and speculation. Hedgers use futures to wedge their assets from unprecedented downward market turns. In contrast, speculators use futures to speculate market prices to know if they’re headed upward or downward.
While this seems like pretty much everything futures can do, there are still other things they’re useful for, and why you should trade with them.
Futures are a great way to diversify your portfolio, as they give you direct access to underlying commodity assets in a way that the equities market can’t. Also, they give you access to unique assets that can’t be readily found in other markets. Additionally, futures help build new risk management strategies depending on market movements.
Future helps you reduce taxes compared to other short-trading markets because profits are taxed on a 60/40 basis. Unlike stock trading, where profits are taxed as 100% ordinary income, futures profits are taxed like this; 60% of taxes under long-term capital gains, while 40% are taxed as ordinary income. Note that taxes are calculated differently in different countries, so ensure that you do more research to know if the terms are different in your country.
Futures offers you leverage by requiring 3-10% of the underlying asset’s value in the contract. With this kind of leverage, you could potentially make more significant returns on the capital invested. Still, it also carries an amount of risk, as you could lose more than you originally invested.
What Are Futures Contracts?
A futures contract is a standardized agreement where the buyer and seller set an agreed price and quantity of a commodity/asset to be delivered at a future date. This contract can be tradeable on an exchange. Futures prices are set using a mathematical technique that calculates the current spot price, risk-free rate of interest, maturity time, dividend yields, and convenience yields.
Once prices are set, a standard quantity is determined, depending on the commodity involved. For example, one gold contract is listed for 100 troy ounces of gold on the Chicago Mercantile Exchange (CME). When these contracts are created, they can be bought by investors and retail traders who can resell and profit from them. A futures contract can be purchased and traded before it expires purely for profits.
Traders do this by checking the expiration date and contract specifications. For example, if gold is traded at $1,000 per troy ounce and a trader predicts that it could increase to $1,200 in 4 months, he could buy a gold futures contract worth $110,000 (100 troy ounces standard quantity x $1100) that expires in 6 months.
Note that the trader is not required to pay the $110,000 outright. Instead, he will only pay an initial margin payment to the broker, which might cost a few thousand dollars. Depending on the profit or loss fluctuations, the trader might have to deposit more money— maintenance margin— especially if the futures position suffers a loss.
When this contract is closed, the final profit or loss is calculated— the contract is completed when the trader resells the contract. If the trader resells for $1200 per troy ounce when the price has increased, he could either make $10,000 or lose it if the price drops to $1,000.
Futures are contracts where buyers and sellers of an underlying asset set a price and agree to trade the underlying asset at a future date. There are many uses and benefits of futures, like hedging risks, speculating price movements, tax benefits, and leverage. Using futures for trading in the financial market is beneficial, but as always, ensure to do more research and read contracts well before engaging in a futures contract.
Founder & CEO of Vestinda.
Compacting years of investment portfolio building into just a few minutes.