20 Investments: Futures Contract
What Is It?
As the name implies, futures are contracts on commodities, currencies, and stock market indexes that attempt to predict the value of these securities at some date in the future.
The popular perception of futures is that they are a form of very high risk speculation. This is true. But futures are also widely used as financial tools for reducing risk. Futures speculators invest in commodity futures in the same way others invest in stocks and bonds, and mutual fund managers also use futures to hedge against risk. The primary purpose of futures markets is to provide an efficient and effective mechanism for the management of price risks. Futures traders accept price risks from producers and users with the idea of making substantial profits.
A futures contract on a commodity is a commitment to deliver or receive a specific quantity and quality of a commodity during a designated month at a price determined by the futures market. For example, someone buying an April Canola contract at $5 a pound is obligated to accept delivery of 100 pounds of canola during the month of April at $5 per pound. Selling a futures contract means you are obligated to deliver these goods. The same concept applies to buying a futures contract on any other asset. It is important to know that a very high portion of futures contracts trades never lead to delivery of the underlying asset; most contracts are "closed out" before the delivery date. (For an in-depth look at the futures market, read our Futures Fundamentals tutorial.)
Objectives and Risks
There are two reasons to use commodity futures contracts: to hedge a price risk or to speculate. What do we mean by hedging? Let's say you are a farmer and you have 1,000 pounds of wheat to sell. You could either wait until harvest and sell your wheat at the current market price, or you could use a futures contract to "lock-in" the price today. If you are satisfied with the price of wheat today, then you will sell (or short) the appropriate wheat futures contract. By shorting the contract, you are guaranteeing that you will get today's price at harvest time. How does that work? The gain (or loss) on the futures contract will equal the gain (or loss) on the market price at harvest time - this is called a perfect hedge. A mutual fund manager would use this same strategy, but with index futures. He or she would short futures contracts on a stock index, therefore reducing any downside risk for a certain period of time.
The risks associated with futures contracts apply mainly to speculators. Speculators take positions on their expectations of future price movement, often with no intention of either making or taking delivery of the commodity. They buy when they anticipate rising prices and sell when they anticipate declining prices. The reason futures are so risky is because they are usually bought on margin, and each futures contract represents a large amount of the underlying asset. For example, a bond futures contract might cost $10,000 but represent $100,000 in bonds. Futures rules state that you only need to deposit 5-10% down and the rest of the contract can be purchased through the use of margin. (To learn more about the advantages and risks of margin trading, read our Margin Trading tutorial.)
The bottom line is that you should only invest in futures if you are very experienced and you have a lot of money.
How To Buy or Sell It
Futures can be purchased through most full-service and some discount brokers. There are also brokers that specialize in futures trading.
Futures are extremely useful in reducing unwanted risk.
Futures markets are very active, so liquidating your contracts is usually easy. |
Futures are considered one of the riskiest investments in the financial markets - they are for professionals only.
In volatile markets, it\'s very easy to lose your original investment.
The very high amount of leverage can create enormous capital gains and losses, you must be fully aware of any tax consequences. |
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Hedge Against Risk |