subject: Understanding Futures Contracts [print this page] One of the flourishing investment options in the recent times is the futures contract. A form of derivatives, it is a contract to buy or sell a specified asset for an agreed price at a future date. These contracts are traded on a futures exchange and the underlying asset could be any commodity, currency, financial instrument etc. Read on to know how these futures contracts can be effectively used as hedging and speculative tools.
Futures in detail:
Holder of the contract is obliged to make or take delivery of the asset as per the contract.
The contract can be settled i.e., fulfilled either in case or can be a physical settlement.
Futures are exchange traded and are standardized. A contract must specify the underlying asset, the currency of the contract, the asset delivery month.
Comparatively less initial costs, presence of an organized stock market, standardized contracts, greater liquidity are contributing to the growing popularity of futures however, one must be fully aware of futures pricing, strategies to reap maximum benefits. The core of futures contracts lies in predicting whether the price of the asset will rise of fall in the future. Depending on various inputs from market analysis one can predict the movement of price and enter into either buy or sell contracts at a price fixed today.
Futures are broadly classified based on their settlement. Contracts traded for physical delivery like agricultural commodities, crude oil etc are commodity futures while contracts which are settled for cash like bonds, treasury notes etc are financial futures.
Trading in futures is involves three basic steps:
Entering into a contract A future contract consists of lots of the underlying assets. For ex: A futures contract for shares of XYZ company consists of 100 or 250 or 650 shares. The lot size varies based on the underlying asset.
Payment of Margin A buyer of the future contract just pays the margin amount and not the entire value of the contract. The margin is usually a percentage on the contract amount and is prescribed by the exchange.
Trading Depending on the price movements of the underlying asset, your margin amount is either credited (increase in price of asset) or debited (decrease in price of asset). Such amendments to your margin amount are undertaken till either expiry of the contract or sale of the contract.
Futures contracts are both profitable and risky. It is advisable to have a thorough understanding of derivative market and futures prior to entering into them.
