Whether you're new to investing or you're been trading on the markets for some time now, you'll have probably heard of the term 'futures contract', but might not fully understand what it is and how it can impact your investment.
So, what is exactly is a futures contract? A futures contract is a legal agreement to buy or sell a particular asset on a set future date at an agreed price. They're a standardised agreement that typically trades on an exchange of the goods or of the agreement.
The futures market are typically used by hedgers and speculators as well as companies that want to purchase a physical product or commodity. It's possible to trade futures in the UK as well as overseas by using an online broker to help facilitate the purchase.
How do futures work?
Futures contracts allow individuals and businesses to secure a specific price for a product or service in order to protect against the possibility of wild price swings (up or down) in the future. Investors and speculators use futures contracts to make money off the price of changes in the contract itself.
For example, a company who wants to lock in the price of a commodity such as crude oil, natural gas, corn, milk or wheat to avoid an unexpected increase could buy a futures contract. This agreement would set out a price for which the commodity would be bought at in the future for a specified date. Equally, a distributer may sell a futures contract to ensure it has a steady market for their commodity in order to protect their asset against an unexpected decline in prices.
Should the price of the commodity rise, the futures contract itself becomes more valuable. This means that the owner of the contract could sell it for more in the futures market – without ever having the intention of taking stock of the commodity.
Not just commodities
Whilst commodities represent a large part of the futures-trading world, you can also trade futures of individual stocks, shares, bonds and even cryptocurrency. Futures trading is popular with investors because the margins can be greater compared with the relatively small amount of cash investment.
What's in a futures contract?
You can readily buy and sell futures contracts over exchanges and they are all standardised. Each futures contract will include specific details about the contract including:
* The type of commodity and the unit of measurement
* The quantity of the goods
* The time frame of the trade
* The currency the trade will be carried out in
* Grade or quality of considerations – if appropriate
If you plan on trading in futures, it's important that you don't take physical delivery of a commodity when the contract expires. Instead you will want to sell your futures contract to either an individual or business who does want the commodity or you sell to another buyer (or speculator).