DEFINITION of Futures
A futures contract is a standardized forward contract. A legal agreement to buy or sell something at a predetermined price at a specified time in the future.
WHAT IT IS IN ESSENCE
All futures contracts have an expiry date: the date at which the underlying asset has to be delivered.
They are different from ‘spot’ prices. Delivery date in futures is the date when payment occurs. Because it is a function of an underlying asset, its contract is a derivative product.
Most of these contracts are traded on exchanges, which are best known in a field of commodities trading. The buyer of a contract is ”long position holder”.
Hence, the selling party is short position holder.
Both parties risk their counterparty walking away if the price goes against them. Consequently, the contract may involve both parties lodging a margin of the value of the contract with a mutually trusted third party.
For example, in gold trading, the margin varies between 2% and 20% depending on the volatility of the spot market.
Also, traders are using them to trade other assets such as stock indices. Some of them require the asset itself to change hands, but the others can be paid in cash.
HOW TO USE
They are a way to hedge against other trades or for speculation. For businesses, they are the way to lock in the price of a commodity for the long term, keeping prices stable.
The first contracts of this kind were negotiated for agricultural commodities. But later futures contracts were negotiated for natural resources such as oil.
The financial was introduced in 1972. But in recent decades, currency futures, interest rate futures, and stock market index futures shows an increasingly large role in the overall futures markets.
The original use of this contracts was to reduce the risk of price or exchange rate movements. And to do that by allowing parties to fix prices or rates in advance for future transactions.
For example, this is favorable when a party expects to receive payment in a foreign currency in the future. But wants to guard against an unfavorable movement of the currency in the interval before receiving the payment.