What is Futures Contract?
956 reads · Last updated: December 5, 2024
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Definition
A futures contract is a legal agreement to buy or sell a specific commodity, asset, or security at a predetermined price at a specified time in the future. The quality and quantity of the futures contract are standardized to facilitate trading on a futures exchange. The buyer of a futures contract is obligated to purchase and receive the underlying asset upon the contract's expiration, while the seller is obligated to provide and deliver the underlying asset on the expiration date.
Origin
The origin of futures contracts can be traced back to ancient commodity trading, but the modern futures market began in the 19th century in Chicago, USA. The establishment of the Chicago Board of Trade (CBOT) in 1848 marked the beginning of standardized futures contracts.
Categories and Features
Futures contracts can be categorized into commodity futures and financial futures. Commodity futures include agricultural products, metals, and energy, while financial futures cover currencies, interest rates, and stock indices. The standardized nature of futures contracts makes them easy to trade on exchanges and highly liquid. Their leverage feature allows investors to trade large positions with relatively small capital, but it also increases risk.
Case Studies
A typical case is the Hunt brothers' attempt to corner the silver market in the 1980s using futures contracts. They bought large amounts of silver futures, causing prices to skyrocket, eventually leading to a market crash and their bankruptcy. Another case is during the 2008 financial crisis, where many investors used financial futures to hedge risks. Despite severe market volatility, some hedge funds successfully mitigated losses through futures contracts.
Common Issues
Common issues investors face when using futures contracts include misjudging market volatility and improper use of leverage. The high leverage nature of the futures market can lead to significant losses, so investors need to manage risks carefully. Additionally, many misunderstand futures contracts as purely speculative tools, whereas they are also effective risk management instruments.
