The Futures Contract

Trading futures is a practice that’s pinned on a number of assumptions. When we buy a futures contract, we assume that today’s price represents a good deal, and that by the time the contract matures there will remain sufficient margin for a profit from the transaction. We also assume that there’s no chance we might not be able to offload our contracts before the end date, nor that we’ll have to take delivery of a few thousand pounds worth of wheat. So what is it that underpins our understanding of how futures trading works?

Answer: the contract. The futures contract is the agreement that creates the instrument (futures) that is traded. It is a standard contract, and thereby tradable on a futures exchange, that stipulates a futures transaction between the bearer and the offeror based on the price of some other asset.

A favourite amongst investment funds, pensions and even manufacturers hedging against the rising costs of raw materials, futures contracts have paved the way for investors to profit in leveraged positions from long-term projections of asset price.

But how can the futures contract be defined, and what are the key characteristics of futures trading that contribute to its value as an investment tool?

The offeror purports to enter into an agreement for the sale of some underlying asset at a defined price at some later date for a fractional consideration, which is accepted by the offeree when the futures contract is purchased.

Let’s consider each of these key features in turn.

The underlying asset price determines the value of the futures contract, which has to represent an actuarially close valuation of the right to buy the defined commodity at the quoted time – thus when an asset increases in value, the cost of a futures contract on that asset will also increase (and therefore, the re-sell price of the futures contract).

The defined price allows futures to become an instrument of speculation. If you’re forecasting a dramatic rise in the value of steel, perhaps in recognition of growing demand from emerging economies or a rise in European manufacturing, a futures contract quoting on the basis of today’s prices could pose an attractive instrument for investing.

If, at a later date as on or before that specified the futures contract, the price of steel does happen to rise, you can resell your futures contract or take stock of the cash equivalent of actualization to realize a profit on your trading position. The fractional price point of a futures contract thereby builds in a natural progressive leverage, which allows traders to maximize their returns from their traded capital.

Futures are only tradable by the nature of their underlying contracts, and it is this inherent structure to futures that makes them a viable trading option. By giving traders the added flexibility to leverage long-term positions in commodity markets, or to hedge against other market movements, futures have become a staple trading instrument for investors worldwide.

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