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Future Contracts Explained for Beginners

A futures contract lets traders buy or sell a specific asset at a predetermined price for a later date. Also known as derivatives, a futures contract provides investors with the right to sell or purchase an underlying instrument expecting to make a profit from the price increase or decrease. In other words, one obtains not only an asset but also the right to benefit from price movement in the future.

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In this article, we will answer some of the most common questions. What are futures contracts? What is the difference between a forward and futures contract? Who traders them and why?

What is a Futures Contract?

Futures contracts come as a financial tool that makes it possible for all market participants to assume or offset the risk of price increase or decrease over a specific period. When you buy or sell futures, you obtain the right to buy or sell an asset at a predefined price no matter what happens. This fact ensures specific revenue guarantees although some risk might still occur.

Forward vs Futures Contract

Beginners think that these instruments are the same. It is not true. The key differences to take into account are as follows:

  1. All transactions with futures contracts are held within futures exchanges while forward contracts show an agreement between the two parties eager to buy and sell the asset.
  2. Futures contracts are standardized. IT means they are indispensable to investors, commodity issuers, consumers, or traders. What’s more, according to the futures contract an asset is sold or bought under a fixed price on a predefined date.
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Who Is Involved in Trading Futures Contracts?

As a rule, futures contract traders can be divided into two major categories. They include hedgers and speculators:

  • Hedgers come in the form of individuals or organizations that utilize these financial instruments to prevent the risk of price volatility and protect their assets from unexpected price movement.
  • Speculators introduce independent market participants who actually trade futures contracts the same way as bonds, stocks, and other commodities.

At this point, we need to highlight some of the main benefits of trading futures contracts that can make them a better alternative to bonds or stocks:

  1. The futures market generally features a higher volatility level. It results in contracts’ prices fluctuating more if compared to bonds or stocks. On the one hand, traders will have more chances to make a short-term profit. On the other hand, it definitely brings greater risks.
  2. Futures contrast comes with higher leverage if compared to other investment instruments. An individual can benefit from the full contracts’ value putting only 15% of its initial cost that is used as a margin. In other words, one is able to trade bigger volumes with minimum funds.
  3. Futures traders generally benefit from lower commissions

Last but not least, futures contracts are a part of the commodity market. It means increased liquidity and fast transactions that reduce the timeframe between the decision and order execution.

The Bottom Line

To have futures contracts explained, we need to consider them an alternative investment opportunity that can be processed at lower trading costs. Investors use it as a separate asset category that does not correlate with bonds, stocks, or other types of commodities. Trading futures contracts brings a set of advantages. However, at some point, they may carry even greater risks due to increased market volatility.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.