A futures contract is one of the most common types of derivatives. It is a standardized form of a forward contract, which is used to protect the traders against price fluctuations.
What Is a Futures Contract?
It is an agreement between two parties for trading an asset at an agreed price on a future date, with the price locked in before the asset is sold or purchased. Unlike forward contracts, futures are written not by parties but by exchanges where the contract can be traded. Such standardization makes futures more reliable than forward contracts.
In general, there are two categories of market participants that use futures: hedgers and speculators. Manufacturers or purchasers of an underlying entity hedge or guarantee the price at which the commodity is sold or purchased. Traders, on the other hand, may use futures to bet on the price fluctuations of an underlying entity.
Here’s an example. An oil company can use futures to sell their oil. This way they can lock in a price they will sell their product at, and then deliver the product to the buyer on the contract expiration date. At the same time, the buyer will also benefit from the contract. They will know how much they will pay for the oil in advance and that this price will remain the same until the contract expires.
Futures Contract: How It Works
Now let’s take a more detailed look at the working principle of an FC and the math behind it.
An oil company plans to produce 1 million barrels during the next year. It will be ready for delivery in 12 months.
Let’s assume that the product currently costs $100 per barrel. The company could produce the oil, and then sell it at the current market prices in one year. At that time, the market price can be significantly different than the current one.
If the company believes that the prices will be higher in one year, they may choose not to lock in the price now. But if they believe that $100 is a good price, they can lock in a guaranteed sales price by entering into a futures contract.
If, for example, the one-year oil contracts cost $105 per barrel, then by entering into this contract, the company is obliged to deliver 1 million barrels in one year and is guaranteed to receive $105 million. $105 per barrel is received regardless of market prices at that time.
Futures Contracts in Trading
Traders do not actually buy or sell the underlying entity. They are interested only in the price movements and profit that they get from those fluctuations before the contract expires.
For example, it is now May, and August contracts are trading at $75. If a trader believes that the oil will cost more before the contract expires in August, they could buy the contract at $75. This gives them control over 1,000 barrels. However, they are not required to pay $75,000 ($75 x 1,000 barrels). They only need to make an initial margin payment.
The final profit or loss of the trade becomes known when the trade is closed. If the buyer sells the contract at $80, they make $5,000 (($80 - $75) x 1000). But if the price drops to $70, they lose $5,000.
A futures contract is an agreement between two parties for trading an asset at an agreed price on a future date. Futures contracts are typically used by hedgers to secure the investments against price fluctuations and by speculators to get profit on those fluctuations.