Although it is impossible to predict the future, it is possible to estimate how much certain assets will be worth in a few years. The buyer of a futures contract agrees to take delivery of a commodity at a later date. On the other side, the seller is responsible for delivering the things at the agreed-upon price.
Futures contracts are traded on a wide range of commodities, currencies, interest rates, and indices, and they make up a large part of the financial business. More than 25 billion futures contracts are expected to be sold by 2020, according to the Futures Industry Association (FIA).
How Futures Work
Consider a corn farmer who must invest thousands of dollars at the outset of the planting season in the hopes of profiting after the crop is harvested. A farmer can utilize a futures contract to protect himself from price drops during harvest. Regardless of what the real price of corn is when it matures, the farmer will set a price that insures a profit.
A large food company that uses corn in its manufacturing processes could be the beneficiary of this deal. To protect itself, the corporation will buy that farmer’s contract in order to avoid paying higher prices if there is a supply shortage.
Futures contracts are traded on an exchange, and a clearing house acts as a go-between for buyers and sellers, guaranteeing that the contract is fulfilled on time. Even if contracts aren’t expected to settle for weeks or months, the margin must be paid and maintained to ensure the market’s integrity.
Futures trading is an expensive venture. For example, commodity funds do not own corn silos or oil tanks. Instead, they hold futures contracts that must be renewed before they expire.
They buy futures contracts at higher prices, pay transaction costs, and then sell them before they expire at prices that are near to current values, because the price of the commodity in the future is usually higher than it is now.
That’s why rising prices for commodities like heating oil or natural gas are accompanied by a considerably lower or even negative rate of return for the mutual fund or exchange-traded fund that trades futures instead of holding the actual commodities.
Traders can buy and sell these corn futures contracts, but they don’t want to own any grain. Instead, they’re trying to profit from price fluctuations. A futures contract can be bought and sold indefinitely until it expires. For example, at 10:00 a.m., a trader might buy a crude oil futures contract for $70 and sell it for $72 at 3:00 p.m.
Futures can give you a ballpark figure for how much you’ll have to pay for a range of items. Coffee futures, for example, are climbing as of this writing due to the cold weather that has damaged coffee trees in Brazil, the world’s largest coffee-producing country. If your favorite coffee shop hasn’t limited its bean supply, the futures market suggests it will have to pay more, which will most likely be passed on to your account.
Understanding Futures Risk
Keep in mind that as more cryptocurrency funds enter the market, futures contracts will make up the majority of their assets rather than underlying currencies. There will inevitably be a huge disparity in performance as a result of the excessive degree of volatility.
Futures vs. options
Futures and options are often grouped together when discussing investments because they are both based on “what if” price scenarios. However, there is a substantial difference between the two. By allowing the holder to choose whether or not to exercise the option to buy or sell, options contracts live up to their name. Futures, on the other hand, demand that you take action. Neither party has the authority to end the contract.