Loading the player...
A:

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this is often impossible and, therefore, individuals attempt to neutralize risk as much as possible instead. For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity. (To learn more, read Commodities: The Portfolio Hedge.)

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. For example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

RELATED FAQS
  1. Why do companies enter into futures contracts?

    Learn how companies use futures contracts for the purposes of hedging their exposure to price fluctuations as well as for ... Read Answer >>
  2. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ... Read Answer >>
  3. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
  4. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  5. How can a futures trader exit a position prior to expiration?

    A futures contract is an agreement to buy or sell a commodity at a pre-determined price and quantity at a future date in ... Read Answer >>
  6. How do I set a strike price for a future?

    Find out why futures contracts don't have set strike prices like options or other derivatives, even though price change limits ... Read Answer >>
Related Articles
  1. Investing

    How Are Futures Used To Hedge A Position?

    A futures contract is an arrangement two parties make to buy or sell an asset at a particular price and date in the future.
  2. Markets

    An Introduction To Trading Silver Futures

    Silver Futures are becoming popular trading instruments. Here is a primer on how to trade them.
  3. Markets

    Trading Gold And Silver Futures Contracts

    If you are a hedger or a speculator, gold and silver futures contracts offer a world of profit-making opportunities.
  4. Trading

    Advantages Of Trading Futures Over Stocks (APPL)

    We look at the top eight advantages of trading futures over stocks.
  5. Investing

    Options on Futures

    Options on futures contracts offer another way for day traders to use options. These are traded on the same exchange as the underlying futures contract. Traders should take care to understand ...
  6. Trading

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  7. Trading

    How to Use Commodity Futures to Hedge

    Both producers and consumers of commodities can use futures to hedge. We explain, using a few examples, how to achieve commodity hedging with futures.
  8. Trading

    Futures, Derivatives and Liquidity: More or Less Risky?

    Futures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
  9. ETFs & Mutual Funds

    Introduction To Currency Futures

    The forex market is not the only way for investors and traders to participate in foreign exchange.
  10. Trading

    Getting Started In Foreign Exchange Futures

    Learn how these futures are used for hedging and speculating, and how they are different from traditional futures.
RELATED TERMS
  1. Futures

    A financial contract obligating the buyer to purchase an asset ...
  2. Limit Move

    The largest amount of change that the price of a commodity futures ...
  3. Futures Contract

    A contractual agreement, generally made on the trading floor ...
  4. Buying Hedge

    A transaction that commodities investors undertake to hedge against ...
  5. Short The Basis

    A futures strategy involving the purchase of a futures position ...
  6. Contract Unit

    The actual amount of the underlying asset represented by a single ...
Hot Definitions
  1. Glass-Steagall Act

    An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment ...
  2. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  3. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  4. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  5. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  6. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
Trading Center