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What is a futures contract?
Find out what a futures contract is, how to trade one and how futures contracts are different to options.
Futures, also known as futures contracts, are a type of derivative. With futures, a transaction must be made at a predetermined future date and price.
For example, say you promise a grocery store owner that you’ll buy 1 litre of milk next week at this week’s price. The store owner agrees, because he thinks the price of milk will go down next week, in which case you’ll be forced to overpay. But you think the price of milk will go up, in which case, you’ll save money. You have to fulfill the contract at the agreed upon price, regardless of how the price of milk changes.
There are loads of different things you can get futures contracts for, such as the following:
- Commodity futures, such as crude oil, natural gas, corn or wheat
- Stock index futures, such as for the S&P 500
- Currency futures, such as for the euro and pound
- Precious metals futures, like gold or silver
What’s the difference between options and futures?
At a glance, these look like they’re the same thing, but there’s a key difference.
|These are an obligation to buy or sell the underlying asset at a set price at expiration.||These offer the right to buy or sell at a set price on a set date.|
|Once you’ve entered into a contract, you are bound to fulfill it on the date you agreed upon. You don’t have a choice.||These are kind of like coupons to buy chocolate at a discounted price. If you find the shelf price is actually lower than the coupon rate, you can choose not to use the coupon.|
Pros and cons of futures
- Futures let you speculate on the price movements – for example, it’s likely that people had futures contracts ahead of the Brexit vote on the price of the pound. Although, in this particular case, the unexpected result probably led to a lot of people losing money in this way.
- Companies can hedge the price of raw materials from adverse price movements.
- Futures may only require a deposit of a fraction of the contract price.
- Due to leverage, there’s a risk that you can lose more than the money you originally invested.
- Companies that hedge may lose out on favourable price movements.
- Margin means that your losses may be amplified.
What's leverage?Leverage means you don’t necessarily need to put down 100% of the contract value when you enter into a trade. This is what makes derivatives so dangerous – you could find yourself losing more money than you initially invested.
How do you actually make money with futures?
Futures can seem complicated, especially when you’re looking at physical items like commodities and precious metals. Surely if you’re not in the market for a bunch of milk, there’s no point buying it even if it is for a good price?
This is where the exchange comes into play. There are 2 ways this is dealt with: the product you are buying can be physically delivered or it can be cash settled.
Let’s say, for instance, that you own a sushi restaurant. You could choose to “lock in” a physical delivery of soybeans. This means that if the price goes up, you’ve got the better price. As your restaurant actually uses soybeans, you can have a physical delivery of soybeans and get that smug feeling when you get a better price (assuming it went your way).
Despite this being a nice way to save some money on your raw materials, this isn’t generally how investors use futures. Often, they are used to speculate on the cost, and your typical trader doesn’t actually want a bucket-load of soybeans rocking up on their doorstep. In these cases, the contract can be cash settled.
Going long vs going short
When taking out a futures contract, you can take a long or a short position. This is the same as it is with contract for differences (CFDs), where going short means you think the price will fall and going long means that you think the price will rise. If the price goes the way that you thought it would, then you make a profit. If it goes the other way, you make a loss.
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