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.")

Using Futures Contracts

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 to 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.

Exiting a Position Before Expiration

While a futures contract is similar to an option, where the holder has the right to purchase the underlying security, a futures contract makes both parties to the contract obligated to deliver on the terms of the contract if it is held to settlement. If you do buy a futures contract, you are entering an agreement to purchase the underlying security and if you sell a futures contract you are entering an agreement to sell the underlying asset to another party. (To better understand this concept, read "Futures Fundamentals.")

Over the life of a futures contract, the underlying security will likely move in favor of one holder over the other. So what can the holder with the profit do if they would rather exit the profitable position than hold to settlement? If a futures trader wants to close out a position all he or she needs to do is take an equivalent position that is opposite to the contract he or she already owns. So if you are long three February pork belly contracts, to close this position you would sell three February pork belly contracts.

However, usually this is not done by just selling your existing three contracts to another party, like you would a stock. The positions are usually closed out by entering into a new arrangement with another party. For example, if you purchased three contracts from party A, to close out your position, you would sell three contracts to party B. Because these positions are offsetting, your position in the market is neutralized, and you are effectively out of the position. While this is a little more complicated than just selling the original three contracts, the result is the same.

RELATED FAQS
  1. What is the difference between options and futures?

    An option gives a buyer the right, but not the obligation to buy or sell an asset, A futures contract obligates the buyer ... Read Answer >>
  2. 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 >>
  3. How do S&P 500 futures work?

    Learn about the mechanics of S&P 500 futures contracts, a type of stock index future introduced by the Chicago Mercantile ... Read Answer >>
  4. What do the SP-500, Dow and Nasdaq futures contracts represent?

    A futures contract represents a legally binding agreement to pay or receive the difference between the current price and ... Read Answer >>
Related Articles
  1. Investing

    Trading gold and silver futures contracts

    Gold and silver futures contracts offer a world of profit-making opportunities for those interested in hedging securities or a speculative plays.
  2. Investing

    A Quick Guide for Futures Quotes

    Here is a quick guide for reading and understanding futures markets quotes.
  3. Managing Wealth

    How Do Futures Contracts Work?

    Futures contracts are one of the most important financial innovations in history, but they are often misunderstood. Find out how this contract is used to transfer risk between different parties. ...
  4. Investing

    Investing in Crude Oil Futures: The Risks and Rewards

    Learn about the risks and rewards of trading oil futures contracts. Read about a few strategies to limit the risk in trading oil futures contracts.
  5. Trading

    How To Lock In An Exchange Rate

    Currency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.
  6. Trading

    Curious About Stock Index Futures? Read This First

    You've mastered investing in individual stocks...now what? If you like a challenge, consider stock index futures. Just be careful.
  7. Financial Advisor

    Divorce and Annuities: What Clients Need to Know

    Divorce can be the most financially devastating event in a person’s life. Here’s what your clients need to know about handling annuities in a divorce case.
  8. Investing

    Hedging With ETFs: A Cost-Effective Alternative

    Learn how the benefits of ETFs for hedging are numerous and can be enjoyed by investors of all sizes.
  9. Tech

    Are Smart Contracts the Best of Blockchain?

    Smart contracts may be one of the best innovations to accompany blockchain development.
RELATED TERMS
  1. Futures Contract

    An agreement to buy or sell the underlying commodity or asset ...
  2. Closing Range

    Closing range refers to the range of high and low prices, or ...
  3. Back Month Contract

    A type of futures contract that expires in any month past the ...
  4. Forward Contract

    A customized contract between two parties to buy or sell an asset ...
  5. Physical Delivery

    Physical delivery is a term in an options or futures contract ...
  6. Single Stock Future - SSF

    A single stock futures contract is a standard futures contract ...
Trading Center