Introduction to Futures Contracts: A Beginner's Guide

Published on: Fri Feb 24 2023

Introduction to Futures Contracts: A Beginner's Guide

Futures contracts are financial instruments used in the trading of commodities, securities, and other financial assets. They are contracts/agreements that allow two parties to buy or sell a specific asset at a future date and price. Commodities such as gold, silver, crude oil, agricultural products, and currencies are commonly traded using futures contracts. We will provide a beginner's guide to futures contracts in this article, including their definition, how they work, and their benefits and risks.

Definition of Futures Contracts

Futures contracts are agreements between two parties to buy or sell a specific asset at a future date and price. These contracts are traded on exchanges, which serve as go for buyers and sellers. The standard contract specifications, such as the underlying asset, contract size, delivery schedule/date, and settlement method, are set by the exchanges.

How Futures Contracts Work

Futures contracts are standardized agreements, which means that the exchange predetermines/determines the contract terms. The underlying asset, contract size, delivery date, and settlement method are all specified in the contract. A crude oil futures contract, for example, may specify that the contract size is 1,000 barrels of crude oil, the delivery time is in three months, and the settlement method is the cash settlement.

You must open a futures trading account with a broker who has access to the relevant exchange in order to trade a futures contract. When you buy or sell a futures contract, you could go long (buy) or short (sell). You agree to buy the underlying asset at the agreed-upon price on the delivery date if you go long. You agree to sell the underlying asset at the agreed-upon price on the delivery date if you go short.

Futures contracts are marked-to-market on a daily basis, which either means that profits and losses are calculated/measured using the daily settlement price. If the contract price moves in your favor, you will profit; if it moves in the opposite direction, you will lose. Every day, the profit or loss is settled/resolved, and the account balance is adjusted accordingly.

Benefits of Futures Contracts

There are several benefits to trading futures contracts:

Futures contracts are highly liquid, which means they can be bought and sold on exchanges quickly. Leverage: Futures contracts provide leverage, which means you can control a large portion of an asset with a small amount of capital.

Hedging: Futures contracts can be used to protect against changes in the underlying asset's price. A farmer, for example, can use futures contracts to secure the price of his crops before they are harvested.

A farmer, for example, can use futures contracts to secure the price of his crops before they are harvested

Transparency: Futures contracts are traded on exchanges, which ensure transparency and standardisation.

Diversification: Futures contracts provide /give exposure to a diverse set of assets such as commodities, currencies, and securities.

Risks of Futures Contracts

There are also risks associated with trading futures contracts:

Volatility: Price volatility in futures contracts can result in significant losses.

Margin calls: Even though futures contracts are traded on margin, you must keep a certain amount of margin in your account to cover your positions. If the market moves against you, you may be issued a margin call, which requires/needs you to deposit additional funds in order to keep your positions open.

Counterparty Risk: Because futures contracts are contracts between two parties, there is a risk that the counterparty will breach the contract.

Although futures contracts are typically liquid, there may be times when the market is illiquid, making it difficult to buy or sell contracts.

Futures contracts are financial instruments that allow traders to buy or sell assets at a future date and price. They provide/offer several advantages, such as liquidity, leverage, hedging, transparency, and diversification. Price volatility, margin calls, counterparty risk, and liquidity risk are all risks associated with trading futures contracts.

Before trading futures contracts, it is critical for a beginner to thoroughly research and understand the underlying asset as well as the contract specifications. To manage potential losses, it is also critical to have a solid risk management strategy in place.

Overall, futures contracts may/might serve as a useful tool for traders and investors looking to gain exposure to a diverse and varied range of assets, but they must be approached with caution and a thorough understanding of the risks involved.

Returns are subject to market risk.

Past performance do not assure future returns.

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