If you want to diversify your investment portfolio or hedge against fluctuations in the market, you should know about futures contracts. Futures are powerful financial instruments that enable you to agree on prices for whatever assets you plan to acquire or sell later. In this blog, we will help you understand how futures contracts work with simple examples.
What is a futures contract?
A futures contract is an agreement between two parties to buy or sell a particular asset at a set price on a specific date in the future. These contracts are identical and traded on exchanges, so the terms are consistent, and they offer a regulated environment for trading.
Common underlying assets are:
- Commodities (oil, gold, wheat)
- Currencies (USD, EUR)
- Other financial Assets like stocks, indices, bonds etc.
How do futures contracts work?
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Cost and Date Agreement
You and another investor agree on the cost of some asset and choose some date in the future for the deal.
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Margin Requirement
The minimum amount to open the futures contract is called ‘margin’. This is the security deposit on the total value of the contract.
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Daily Settlement
The contract is marked to market daily. This means that each day, your gain or loss is calculated along with an adjustment in your margin account.
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Closing the Contract
One can leave the contract before the expiration date by making a trade that goes in the opposite direction or wait until the end of the contract for the physical or cash settlement.
Key Concepts to Know
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Leverage
Futures contracts enable you to manage large quantities of assets with a relatively small investment because of leverage.
Example:
If you enter a futures contract for 100 barrels of oil at ₹5,000 per barrel, the total value is ₹5,00,000. You need to deposit only ₹50,000 because the margin requirement is 10%.
Margin Calls
If the market turns against you, you may be obligated to add more money to achieve the minimum margin level.-
Settlement Methods
- Physical Delivery: Physical transfer of the asset.
- Cash Settlement: The profit or loss is traded in.
Real-Life Examples
Hedging with futures
Suppose you are a coffee grower. You are worried that prices may decrease. Coffee is trading today for ₹200 per kilo. You can sell future contracts to hedge that in advance for your next crop.
Result if Prices Fall to ₹180: You sell your coffee in the market at ₹180 but receive ₹20 per kilogram from the futures contract, thereby keeping your price at ₹200.
Outcome if prices move to ₹ 220: You sell your coffee at ₹220 but lose ₹20 per kilogram on the futures contract, still receiving ₹200 per kilogram in total.
Speculating with Futures
You think the gold price will rise in value. It costs ₹80,000 for 10 grams of gold.
You go in and buy a gold futures contract at this price.
If it goes to ₹82,000, you could sell the contract or take delivery, earning ₹2,000 per 10 grams.
If gold is ₹78,000 and you are losing ₹2,000 for every 10 grams.
Advantages of Futures Trading
- Price Protection: Lock in prices to eliminate adverse price shifts.
- Leverage: Manage large assets with less money.
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Liquidity: Futures markets are quite liquid; they have easy entry and exits of positions.
Risks Involved in Futures Trading
- High Leverage Risk: Leverage increases profits but makes losses bigger.
- Market Volatility: Prices can fluctuate significantly, affecting your margin requirements.
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Complexity: Futures contracts could be complicated and wouldn't be advisable for all kinds of investors.
Important Tips for Investors
- Understand the Market: Before you start, learn about the asset you want and how the futures market works.
- Controlling Your Risk: Use stop-loss in your orders and be prepared for margin calls.
- Begin Small: Begin with small amount to get accustomed with the futures trading procedures.
- Consult Professionals: Ask financial advisors for help to make sure your futures trading matches your investment goals.
Futures contracts are flexible ways to hedge against risks and guess future price changes. Knowing how they work and the risks that are involved will help you make more smart choices that improve your investment plan. Keep in mind, though futures can give you big chances, it can also lead to losses in substantial amounts. Always be careful and do homework trading futures. With these important ideas in mind, you are now more prepared to consider whether futures contracts are right for your investment portfolio.
Happy investing!