Futures Contracts: An Overview

Futures Contracts: An Overview

What Is a Futures Contract?

An agreement to purchase or sell an item on a public market at a particular price and predetermined date is known as a futures contract. The value of the underlying asset—which could be a bond, stock, commodity, or currency—is tracked via futures contracts.

On the contract’s expiration date, the buyer of a futures contract is required to take possession of the underlying asset, and the seller is required to make the asset available on that specified date. Certain contracts, like those on the S&P 500 index, are cash-settled, while others, like those requiring the delivery of a tangible asset, like crude oil, are not.

Futures can be used for both speculation and risk management hedging. In order to reduce the risks associated with market volatility and uncertainty, hedgers invest in futures contracts to lock in delivery dates and prices. To hedge against price swings, traders might trade long or short. For instance, a refinery that has excess crude oil in storage may be able to short futures on crude oil.

Using futures contracts, traders can hold both long and short positions based on their predictions about the direction of the market. Usually, traders have no intention of obtaining ownership of the underlying item. In order to avoid any responsibilities, they therefore terminate their employment before the contract’s expiration date.

 

How to Trade Futures Contracts

Futures contracts are standardized for exchange trade and specify a specific quantity. The quality, quantity, delivery date, and location of the asset are all specified in a futures contract. Because futures contracts for the same asset, like copper or soybeans, are identical, trading and ownership transfers are relatively easy. A change in the contract’s market price is the only variable.

The exact underlying asset determines the contract expiration month. For example, futures for soybeans are traded in January, March, May, July, August, September, and November, whereas contracts for copper are exchanged throughout the entire year.

Futures contracts are traded on an exchange such as the Chicago Mercantile Exchange (CME). To trade futures, clients must have an account that has been approved by a prop trading firm such as Topstep. Futures contracts are regulated by the Commodity Futures Trading Commission (CFTC), a federal body.

Futures include a broad spectrum of financial assets and commodities. Futures were originally used for agricultural products like maize and cattle, but today the market is dominated by stock indexes like the S&P 500 and the NASDAQ-100. Without requiring them to hold the underlying assets, contemporary traders can utilize futures to speculate on changes in price.

 

Futures Contracts Margin Conditions

Due to the enormous leverage of futures contracts, traders can control a sizable number of assets with a comparatively small initial investment. The required margin for both long and short positions usually falls between 3 and 10% of the underlying contract value.

Due to the large leverage, traders have the opportunity to earn significant returns on their capital investments. But the opposite is also true. The substantial loss of invested capital is another possible consequence of the high leverage.

 

Key Takeaways

  • Traders can make predictions about the direction of the market via a futures contract.
  • You can use futures as a hedge against changes in price.
  • When a futures contract expires, sellers are required to provide the underlying asset, and buyers are required to accept delivery of it.
  • Certain contracts are fulfilled with cash, while others demand the delivery of a tangible item.