Price fluctuations affect all aspects of an economy. When future prices are unknown and unpredictable, it poses many problems to buyers and sellers of goods or services, as well as investors. If future prices can be fixed in some way, it can bring in a lot more certainty and shield businesses and individuals from volatility in the markets. With the risk of price shocks covered, you can confidently make crucial business and investing decisions.
Futures trading serves this important purpose by allowing you to freeze the future price of an underlying asset.
Table of Contents
Chapter 1: What is Futures Trading
Chapter 2: How Futures Trading Works
Chapter 3: Futures Terminology
Chapter 4: Importance of Futures Market
Chapter 5: Limitations on Futures Trading
Chapter 6: Factors Affecting Futures
Chapter 7: Who Should Use Futures Trading
Chapter 8: How to Start Trading in Futures and Be Successful
In a futures trade, two parties to the deal agree to transact with a financial instrument or a commodity at a future date at a price agreed at present. A contract is drawn up with the terms, the date of the future transaction and the price that will apply at the time of the future transaction, and both parties agree to abide by the contract.
The asset in question may not even be in existence when the contract is drawn up. It may be sourced or manufactured only at the time the transaction is being executed. For example, a trader may enter into a futures contract to deliver 100 bushels of wheat at a specific price and date. The wheat is yet to be grown and harvested but the contract is still valid as the commodity is to be physically delivered only on the date mentioned in the contract.
A future is a derivative instrument because it derives its value from the underlying asset and does not have any value on its own. Usually, commodities such as wheat, corn, and gold, and securities such as stocks are the underlying assets in futures trades. Any asset, whose price is vulnerable to excessive volatility is a good candidate for a futures trade.
- In commodities futures, unprocessed raw materials that are used in manufacturing processes are the usual candidates for trading. For example, wheat, instead of bread, and gold instead of jewelry. This is because processing costs, which will go into converting the raw materials into finished goods, are stable. With these costs being predictable, there is no special need to fix these prices in advance with a futures contract.
- When perishable commodities are traded, the commodity must have sufficient shelf life to enable the future transaction if the need arises. However, it is also important to note that mostly, the actual commodity never changes hands and the transaction is purely financial in nature.
- The commodity’s price must be prone to fluctuation, which creates a need for fixing the price in advance to protect the buyer or seller’s position. A commodity whose price shows little movement up or down can be bought and sold in the open market without affecting either party’s costs significantly. It is the price fluctuation of the underlying commodity or security that makes futures attractive for both hedgers and speculators.
A futures trade is different from a regular investment in stocks. It has some unique characteristics that set it apart.
- A futures trade has a definite end time. The contract expires on the date mentioned in the agreement and either party cannot hold the other to the terms of the contract beyond the date. A straightforward investment directly in the stocks of a company can be held indefinitely by the investor as long as the company is in existence.
- Unlike most other investments, physical commodities can be traded with futures. This makes futures trading an effective tool to insulate manufacturing costs from volatility, and to make the returns from manufacturing of goods more certain.
- Price may change very quickly and very frequently in the futures markets. Much more fluctuation and volatility is usually seen in the futures market than in the cash market.
- Futures trading surpasses geographical boundaries to create a global marketplace for commodities. A trader from the US can have a futures contract with a manufacturer in France just as easily as two parties can transact within the same country.
A futures trade can be quite complex and it requires careful planning and good judgment of what the future will bring in terms of prices of the underlying asset. The futures market allows market players to protect themselves from pricing risks through a highly effective and inexpensive transaction.
Next Chapter: How Futures Trading Works