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

FAQs

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

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.

Definition: A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future.

Hedgers. An oil producer needs to sell its oil. They may use futures contracts to lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets.

The Risks of Trading Futures

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.

Lack of discipline is a major shortcoming.

Trading against the trend, especially without reasonable stops, and insufficient capital to trade with and/or improper money management are major causes of large losses in the futures markets; however, a large capital base alone does not guarantee success.

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.

Futures are derivatives, which are financial contracts whose value comes from changes in the price of the underlying asset. Stock market futures trading obligates the buyer to purchase or the seller to sell a stock or set of stocks at a predetermined future date and price.

Unlike investing in shares where you usually buy first and sell later, futures allow you to sell first and buy back later if you desire. This enables you to take advantage of falling prices as well as rising prices. Selling a futures contract is known as being 'short futures'.

How do you make money on futures contracts? ›

Futures contract expiration is the countdown clock of this part of the trading world. It marks the last day that you can trade a futures contract before it expires. After this day, the contract is settled either in cash or through the physical delivery of the underlying asset, depending on the terms of the agreement.

In short, the price of a futures contract (FP) will be equal to the spot price (SP) plus the net cost incurred in carrying the asset till the maturity date of the futures contract. Here Carry Cost refers to the cost of holding the asset till the futures contract matures.

Three elements appear to determine whether a futures contract succeeds or fails: 1. There must be a commercial need for hedging; 2. A pool of speculators must be attracted to the market; and 3. Public policy must not be too discouraging of futures trading.

A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.

All futures contracts have a specified date on which they expire. Prior to the expiration date, traders have a number of options to either close out or extend their open positions without holding the trade to expiration, but some traders will choose to hold the contract and go to settlement.

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.

There are many advantages and disadvantages of future contracts. The most common advantages include easy pricing, high liquidity, and risk hedging. The major disadvantages include no control over future events, price fluctuations, and the potential reduction in asset prices as the expiration date approaches.

A negative call price implies that the option writer pays the option purchaser to take the option. In the absence of significant market frictions, negative option prices should not be observed in well-functioning financial markets.

Futures tend to be riskier as they are directly aligned to the asset prices and their volatility. On the other hand, Options react differently to the underlying asset price movements and allow you relatively more time to manoeuvre and curtail losses.