What Are Futures Contracts? #
A Futures Contracts are a type of derivative contract in which two parties agree to buy or sell a specific quantity of an asset at a predetermined price on a specified future date.
Unlike the spot market, where the underlying asset itself is exchanged, futures trading involves contracts whose value is derived from the price of an underlying asset.
The underlying asset can be a stock, commodity, currency, market index, cryptocurrency, or many other types of financial assets.
Why Are They Called “Futures” Contracts? #
The term futures refers to the fact that these contracts are based on an agreement to complete a transaction at a future date.
Although most modern futures positions are closed before their expiration date and the underlying asset is never actually delivered, the original concept of futures trading was built around agreements for future delivery at a price agreed upon today.
Why Were Futures Contracts Created? #
Futures contracts were originally developed as a tool for hedging, or managing price risk.
Imagine a farmer who expects to harvest wheat six months from now but is concerned that wheat prices may fall before the harvest. At the same time, a flour manufacturer may worry that wheat prices will rise, increasing production costs.
A futures contract allows both parties to agree today on the price at which the wheat will be bought and sold in the future.
If wheat prices decline, the farmer is protected because the crop can still be sold at the agreed price. If prices increase, the manufacturer benefits by purchasing the wheat at the predetermined price rather than the higher market price.
In this way, futures contracts were originally designed to reduce the uncertainty caused by price fluctuations.
How Are Futures Used Today? #
Although futures contracts were created primarily for risk management, they are now widely used by traders and investors around the world.
Most market participants have no intention of taking delivery of the underlying asset. Instead, they use futures contracts to profit from changes in market prices.
As a result, futures markets have evolved into one of the most important venues for trading and investment in modern financial markets.
Which Assets Have Futures Contracts? #
Today, futures contracts are available for a wide variety of financial and physical assets, including:
- Stocks
- Stock market indices
- Gold and silver
- Crude oil and natural gas
- Agricultural products
- Currencies
- Cryptocurrencies
In every case, the value of the futures contract is linked to the price of its underlying asset.
Key Characteristics of Futures Contracts #
Futures contracts have several important features that distinguish them from spot market transactions.
Rather than purchasing the actual asset, traders buy and sell standardized contracts whose value depends on an underlying asset. These contracts are created according to predefined specifications, including contract size, expiration date, and settlement procedures established by the relevant exchange.
Futures markets also allow traders to profit from both rising and falling prices. In addition, many futures markets offer financial leverage, enabling traders to control larger positions with a smaller amount of capital. While leverage can increase potential returns, it also increases the risk of losses.
Is the Underlying Asset Always Delivered? #
No.
Although futures contracts were originally designed for the future delivery of an asset, most contracts today are closed before expiration.
Instead of exchanging the actual asset, traders typically settle the profit or loss resulting from the difference between the entry price and the exit price.
For this reason, only a relatively small percentage of futures contracts result in the physical delivery of the underlying asset.
Summary #
A futures contract is a derivative instrument whose value is based on an underlying asset. Originally developed to help market participants manage price risk, futures contracts have become one of the most widely used financial instruments for trading, investing, and hedging in global financial markets.
One-Sentence #
A futures contract is an agreement to buy or sell an asset at a predetermined price on a future date and is now widely used for both risk management and trading price movements.