Finance

What are Futures Contracts? How Do They Work?

3 Mins read

Investors consider Futures Contract to secure exposure to specific assets or markets. They allow investors to mitigate risk and speculate on price movements. Let us understand better how they work and what is the concept all about. 

Meaning of Future Contracts

A Future Contract is a legally binding agreement to buy or sell an asset at a future date and price. They are often used in Commodities Trading and apply to stocks, currencies, and other financial instruments. When you invest in a Future Contract, you essentially invest in the asset’s future price. If you believe the price will go up, you buy the contract. 

If you believe the price will go down, you sell the contract. They are a Derivative type, meaning their value is derived from the underlying asset. For example, Futures Contracts on gold depend on the gold price at the time of the contract. They can be traded on exchanges or Over The Counter. Most contracts have a standard size and are traded in large quantities, but some OTC is customisable to fit the buyer and seller’s needs.

How do they work?

Futures Investment is a financial contract that obligates two parties to transact an asset at a specified price and future date. They are used for hedging, speculation, and arbitrage in the commodities, securities, and foreign exchange markets. It is an agreement between two parties to buy or sell an asset at a specific price on a future date. The contract buyer agrees to purchase the asset, while the seller agrees to sell the asset. 

Both parties are obligated to fulfil the contract terms. Futures Contracts are commonly used in the commodities, securities, and foreign exchange markets. In Commodity Markets, investors often use Futures Contracts to hedge against price fluctuations. For example, if a farmer expects the price of wheat to rise in the future, they can buy a wheat futures contract. 

This contract offers the right to purchase wheat at a set price on a future date. If the prices rise as expected, the farmer can sell their wheat at a profit. 

What are the benefits of Future Contracts?

Futures Trading is an agreement to buy or sell an asset at a future date. Exchanges standardise them, and the buyer and seller need not know each other. Futures are used to hedge against price risk and can be traded for speculation. Futures Contracts trade at a margin, the difference between the Futures and Spot Price. The margin is the collateral for the contract. 

If the underlying asset’s price moves against the Futures trader, they should post additional collateral. Futures can be traded for speculation. Speculators take on price risk to profit from changes in asset prices. They do not use Futures to hedge risks. 

Futures are Derivatives, meaning their value is derived from an underlying asset. The underlying asset can be a commodity, like corn or oil, or a financial instrument, like Stocks and Currencies. Futures Derivatives can be risky, but they can also be profitable. Those who consider them should research the contracts they are interested in and understand the risks before trading.

ICICI Securities Ltd. (I-Sec). The registered office of I-Sec is at ICICI Securities Ltd. – ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai – 400 025, India, Tel No: 022 – 6807 7100. I-Sec is a Member of the National Stock Exchange of India Ltd (Member Code:07730), BSE Ltd (Member Code:103) and Member of Multi Commodity Exchange of India Ltd. (Member Code: 56250) and has SEBI registration no. INZ000183631. Name of the Compliance Officer (broking): Mr Anoop Goyal, Contact number: 022-40701000, E-mail address: complianceofficer@icicisecurities.com. Investments in the securities market are subject to market risks, read all the related documents carefully before investing. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purposes and may not be used or considered as an offer document or solicitation of an offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investors should consult their financial advisers about whether the product is suitable for them before taking any decision. The contents herein mentioned are solely for informational and educational purposes.

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