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What is a futures contract?
Find out what futures contracts are and how you can trade them.
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. It’s kind of like going into a shop and promising to purchase a pint of milk in a week’s time for the price they’ve got on display right now. If everyone agrees to it, you’ve got yourself a futures contract.
For example, if you agree to buy a pint of milk for £1 and in a week’s time it costs £1.20, then you can still have it for £1. If it’s 80p, that sucks, you gotta buy it for £1. And that’s not a choice – you have to fulfil your contract and purchase your milk at the agreed price.
The analogy kind of falls apart here since you could just go in with a fake moustache and buy a pint of milk for the bargain price of 80p but that’s the gist.
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.
| Futures | Options |
|---|---|
| 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 have to fulfil it at the price and on the date you agreed upon – much like when you exchange contracts on a house purchase. | These are kind of like a voucher for a cheaper bar of chocolate. If you arrive at the supermarket to purchase it and the shelf price is a better price than your voucher, you can choose not to use it. |
Pros and cons of futures
Pros
- 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.
Cons
- 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 two 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 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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