Derivatives 101: How Futures Contracts Work

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Futures are one of the most lucrative markets for investors who invest in different kinds of derivatives, along with others like options, swaps, and CFDs.

futures contract illustrated


The futures market is a centralized marketplace for buyers and sellers across the world, and it’s where they meet and enter futures contracts. Even though trading took place using an open outcry system in exchange trading pits, most exchanges these days use electronic trading systems, which help them lower the trading costs and quicken execution.

Each futures contract is dedicated to the underlying commodity or financial instrument and the delivery date. The prices for each contract fluctuate throughout the trading session in response to economic events and market activity.

What exactly is futures contract?

Imagine you want to buy something and you want to enter into an agreement with the seller to receive a specific number of items at a predetermined set every month for the next year. This agreement made with the seller is very much like a futures contract in the manner that you have agreed to receive a product at a future date. The price and terms for the delivery are also pre-set.

That means you have secured your price for the next 12 months even if the price of the product rises within that time. By entering into this agreement, you have lowered the chance of you paying at a higher price in the future.

The futures market works in very much a similar way. The items may be commodities like wheat products, oil, and gold. Investors in this market usually try to pin down the buying price to determine how much products they can make and at what profit.

The most important takeaway in here is that a futures contract is a deal between two parties; one of them is holding a short position. He’s the one who agrees to deliver the commodities. The other one is holding a long position. He’s the party that agrees to receive a commodity.

Not Only Commodities

Although commodities represent a huge part of the futures market, they’re not all about wheat, crops, oil, and gold. You can also trade futures shares of exchange-traded funds and even individual stocks and bonds. If it hits your fancy to trade Bitcoin futures, you can do so.

Traders dig these vehicles because of the greater potential for leverage than simply directly owning the security. You can take a substantial position while whipping out a relatively small amount of funds.

For instance, if you want to hedge exposure to the US stock market, you may short-sell a futures contract on the S&P 500. If the stocks fall, you can make money on the short, balancing out your exposure to the index.  On the flip side, you may feel confident in the future and buy  a long contract so you can gain a lot of upside  if the stocks shoot through the roof.

Conclusions

Futures contracts are one of the most popular go-to investments of those who want to diminish the overall costs of their investments, hedging away from risks in the process. However, remember that every good investment carries with it inherent risks that you have to manage. In order to profit from them, you need to understand how they work as well as how to properly manage risks.

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