Futures Contract: Meaning, Definition, Pros & Cons | 5paisa (2024)

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Futures Contract: Meaning, Definition, Pros & Cons | 5paisa? ›

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.

Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.

What is a futures contract? A futures contract is a legally binding agreement to buy or sell a standardized asset on a specific date or during a specific month. Typically, futures contracts are traded electronically on exchanges such as the CME Group, the largest futures exchange in the United States.

Hedgers. These are businesses or individuals that use futures contracts for protection against volatile price movements in the underlying commodity. A good example to illustrate hedging would be a corn farmer and a corn canner.

Advantages of futures trading include access to leverage and hedging while disadvantages include overleveraging and challenges presented by expiry dates. Choose a futures trading platform that is intuitive, offers multiple order types, and has competitive fees and commissions.

A futures contract allows an investor to speculate on the direction of a security, commodity, or financial instrument, either long or short, using leverage. Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.

Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change. Let's look at how this might work for businesses using the coffee industry as an example.

Every futures contract has an expiration date. CME Group's Micro E-mini futures contracts expire on a quarterly basis, settling to the official opening level of their respective index on the third Friday of March, June, September and December.

The different types of futures contracts include equity futures, index futures, commodity futures, currency futures, interest rate futures, VIX futures, etc.

Futures contracts do not pay dividends. The profit or loss from a futures position comes from the change in the underlying asset's price.

Why buy futures instead of stocks? ›

Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock.

Many financial futures contracts, such as the popular E-mini contracts, are cash settled upon expiration. This means on the last day of trading, the value of the contract is marked to market and the trader's account is debited or credited depending on whether there is a profit or loss.

You can buy or sell a futures contract. If you buy the contract, you agree to pay a certain price on a certain date. If you sell a contract, you agree to provide the underlying asset at the specified price.

Options are generally considered safer than futures because the potential loss in options trading is limited to the premium paid, whereas futures carry higher risk due to potential unlimited losses resulting from leverage and market movements.

Lack of a clear strategy: Futures and options trading requires a well-defined strategy. If investors do not have a clear plan, exit strategy, or risk management, they may make impulsive decisions that lead to losses.

Where futures and options are concerned, your level of tolerance of risk may be a contributing variable, but it's a given that futures are more risky than options. Even slight shifts that take place in the price of an underlying asset affect trading, more than that while trading in options.

Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.

Low Execution Cost

To own a futures contract, an investor only has to put up a small fraction of the value of the contract (usually around 10%) as margin. The margin required to hold a futures contract is therefore small and if he has predicted the market movement correctly, he receives huge profits.

Hedging can be an effective way to mitigate risks in trading. However, it is essential to weigh the pros and cons before using this strategy. While it can protect against losses and increase confidence, it can also be costly, limit profit potential, and be a complex strategy to execute.

Futures have several advantages over options in the sense that they are often easier to understand and value, have greater margin use, and are often more liquid. Still, futures are themselves more complex than the underlying assets that they track. Be sure to understand all risks involved before trading futures.