What are Futures?
The meaning of futures contract refers to a standardized agreement between two parties to buy or sell an asset at a predetermined future date and price. It is a form of derivative instrument that derives its value from the underlying asset. Futures contracts are used by investors, producers, and traders to manage risk associated with price volatility of an asset or group of assets. They are also used as hedging tools in the commodities markets for both agricultural products such as corn and wheat, and energy commodities such as oil and natural gas. In some cases, futures can be used for speculation, which involves buying contracts with the hope that their prices will increase in the future. In most cases though, they are used to hedge against price changes in order to reduce losses resulting from unfavorable market conditions. The buyer of a futures contract is said to be taking a “long” position, while the seller is taking a “short” position. Both parties must meet the obligations outlined in the agreement when it expires, which is typically done by entering an offsetting trade prior to expiry. Overall, futures contracts are a form of hedging or risk management tool that enable investors and traders to manage volatility associated with assets. They also provide liquidity for markets and allow for price discovery between buyers and sellers of commodities.
Additionally, futures contracts are used to create margin accounts, which allow traders and investors to leverage their capital by trading on margin. This is done by posting a collateral with the exchange in order to enter into more trades than would otherwise be possible with their existing funds. Margin accounts require close monitoring of positions as losses can quickly exceed the initial deposit due to the high degree of risk associated with leveraged trading. Furthermore, speculators may use futures markets as a way to bet on future price movements in an attempt to profit from them. While it can be a very lucrative strategy, futures trading also carries high risks that should not be taken lightly.
Simplified Example
Futures are like making a promise to buy or sell something at a later date. Imagine you and your friend are playing a game and you want to trade toys with them. You agree that next week you will give them your toy car, and in exchange, they will give you their toy train. You promise to trade the toys at a later date. This is similar to a future in finance. A future is a contract where two parties agree to trade an asset, like a commodity, currency or stock, at a specific date in the future and at a specific price. It's like making a promise to buy or sell something at a later date, just like you promised your friend to trade toys next week.
The History of Futures
The term "futures" in finance originated centuries ago, stemming from early agricultural practices. In ancient times, farmers and merchants engaged in agreements to buy or sell goods at predetermined prices for future delivery, essentially establishing the foundational concept of futures contracts. This practice aimed to mitigate the risks of price fluctuations, allowing parties to secure prices in advance, regardless of market volatility. Over time, this approach evolved and expanded beyond agricultural commodities to encompass various financial assets like currencies, stocks, and commodities, culminating in the establishment of formalized futures markets.
The development of regulated futures exchanges in the late 19th and early 20th centuries, notably the Chicago Board of Trade (CBOT) in 1848, formalized standardized futures contracts, fostering liquidity, risk management, and speculation within financial markets.
Examples
Derivatives: These are financial instruments whose value is derived from an underlying asset such as stocks, bonds or commodities. They allow investors to speculate on the future direction of asset prices and manage risk by hedging against potential losses. Examples include futures contracts, options, swaps and Forward Rate Agreements (FRAs).
Exchange Traded Funds (ETFs): ETFs combine elements of both mutual funds and individual securities. They track a wide range of assets and can be traded like stocks on major exchanges, providing a cost-effective way for investors to diversify their portfolios without taking on high levels of risk. ETFs also offer exposure to certain sectors or even specific countries that may otherwise be inaccessible to small investors.
Structured Products: Structured products are tailored financial instruments created by banks and other financial institutions for the purpose of providing investors with a unique combination of risk, return and capital protection features. They are complex investment vehicles that can be used to hedge against market volatility or take advantage of specific market opportunities, often involving the use of derivatives such as options or swaps. These investments typically require a large amount of capital and often come with high fees, so they tend to be suitable only for experienced investors who understand their risks and rewards.