Financial markets are the places where individuals buy and sell things including stocks, currencies, gold, oil, and other goods. The financial markets can be transacted in a lot of different ways. The methods are more or less straightforward.
A futures contract is one of those complex methods of trading. Futures contracts are a derivative, i.e. it is founded on something. In this case, it will be pegged on the price of a stock, commodity or any other financial instrument.
Futures contracts allow futures traders to purchase or sell a future at a price that they would accept currently. A futures contract is not the same as either selling or buying something today in the regular market. Futures contracts enable traders to either make a profit at the future or insure against a risky position.
In this article, the definition of futures contracts will be explained in a very simplified manner and the working of futures contracts will also be explained step by step so that everyone can have a clear vision of how futures contracts operate.
What Is A Futures Contract?
Futures contract is a contract between two individuals. One is prepared to purchase in the future. Another man accepts to sell it in future.
- The buyer is called “long.”
- The seller is called “short.”
The price and date of the contract are definite. It implies that the buyer and seller have to carry out the exchange of the item at that price on that date. They are not able to select another date as it is in a forward contract.
The future contract product may be:
- Stocks
- Goods (such as oil, gold, wheat)
- Currencies
- Bonds
- Interest rates
Futures contracts are binding. The agreement has to be adhered to by both sides.
How Do Futures Contracts Work?
Futures contracts work like a promise. Let’s say you agree to buy gold in three months at $1,800 per ounce.
- If the price goes up in three months to $1,900, you still pay $1,800. You gain money.
- If the price goes down to $1,700, you still pay $1,800. You lose money.
Traders use futures contracts for two main reasons:
- Hedging – Protect themselves from price changes.
- Speculating – Try to make money from price changes.
The contract is usually traded on a futures exchange, which acts like a helper. The exchange makes sure the trade happens safely.
Margin And Marking To Market
When traders buy a futures contract, they don’t pay the full price immediately. They pay a small part called margin.
- Margin is a security deposit.
- It protects the exchange from losses.
Every day, the futures price can go up or down. The change is called marking to market.
- If the price goes up, the buyer’s account is credited.
- If the price goes down, the buyer’s account is debited.
The margin must be refilled if it runs out. This keeps the trade safe.
Standardized Futures Contracts
Futures contracts are standardized. This means:
- The quality and quantity of the item is fixed.
- The delivery date is fixed.
- Only the price changes.
This makes it easy to trade contracts. You can also sell your contract to someone else.
Exchange-Traded Futures Contracts
Futures contracts are traded on an exchange. This has many benefits:
- The exchange acts as a middleman.
- The buyer and seller don’t need to know each other.
- The contract is guaranteed to be honored
- It reduces risk for both sides.
- Traders can enter and exit the market easily.
The exchange also makes the market liquid, which means it’s easy to buy and sell.
Buying Futures Contracts
To buy a futures contract, a trader must:
- Open a trading account with a broker.
- Deposit funds in the account.
- Choose the contract to buy.
The broker helps the trader place an order. The order has details like:
- Name of the item (commodity, stock, etc.)
- Expiry month
- Contract size
- Price
The broker then sends the order to the exchange. The exchange matches the buyer with a seller.
The trader only pays the margin, not the full price.
Selling Futures Contracts
Selling futures contracts works in a similar way. Traders can sell:
- Before expiry – Close their position early.
- On expiry – Wait until the contract ends and settle the price difference.
If the trader sells early, the profit or loss is calculated immediately.
If the trader waits until expiry, the contract is settled at the final price.
Commodity Futures Trading
A commodity futures contract is for items like:
- Oil
- Gold
- Silver
- Corn
- Wheat
The price and delivery date are fixed in advance.
Traders can use commodity futures to:
- Protect an existing investment (hedging)
- Bet on price movements (speculating)
Commodity futures can have high leverage. This means traders can trade a large contract with a small deposit.
High leverage is risky. If the trade goes wrong, the trader can lose a lot of money.
Example Of Futures Trading
Let’s say a trader in Qatar grows 1 million barrels of oil.
- Current price = $80 per barrel
- Delivery = next year
The trader is worried the price might fall. They can enter a futures contract to sell oil at $80 next year.
- If the price falls to $70, the trader doesn’t lose money.
- If the price rises to $90, the trader could have earned more, but they locked in $80.
This is how futures contracts protect against price changes.
How The Futures Price Is Calculated
The price of a futures contract depends on:
- Spot price – Current market price of the asset
- Time to maturity – How long until delivery
- Storage costs – If the asset needs storage
- Dividends or interest – If applicable
This helps both parties agree on a fair price.
Advantages Of Futures Contracts
- Hedging – Protect investments from price changes
- Speculation – Make profits from price movements
- Leverage – Trade big contracts with small money
- Liquidity – Easy to buy and sell on the exchange
- Transparency – Prices are clear and standardized
Risks Of Futures Contracts
- Leverage risk – Losses can be large
- Market risk – Prices may move in the wrong direction
- Obligation – Buyer and seller must fulfill the contract
- Delivery risk – Physical commodities may need handling
Futures contracts are not for beginners without experience.
Conclusion
- A futures contract is a deal to buy or sell an asset at a set price and date.
- The buyer is long, the seller is short.
- It is used to hedge risk or make profits.
- Futures contracts are standardized and traded on an exchange.
- Traders pay a margin and may face gains or losses every day.
- Commodity futures include oil, gold, silver, wheat, and corn.
- Futures contracts can be risky but helpful if used properly.
Tips For Beginners
Establish an account with a reputable broker like InvestFW or Capitalix.
- Adjust increments and begin with a smaller contract for practice.
- Understand margin and leverage before placing bigger volume trades.
- Pay attention to the market on a daily basis.
- Read more in terms of books and guides about futures contracts.
Futures contracts can be a powerful tool in trading but require knowledge and experience.
FAQs
Q1: What is a futures contract?
A futures contract is an agreement to buy or sell something at a predetermined price and date in the future.
Q2: Can I profit from trading futures?
Yes. If market prices move in your favor, you can profit from futures. The opposite can also hold true, if the prices move against you, you can incur losses.
Q3: Do I pay for a futures contract in full?
Futures contracts don’t involve this, you pay a small margin and the remainder is settled through your broker.
Q4: What can I trade using futures?
You can trade commodities e.g. oil, gold, wheat, stocks, currencies, and bonds.
Q5: Is futures trading unsafe for new traders?
It can involve risk. New traders may consider starting small and using a reputable broker.
