Explanation of Futures Contracts
Futures Contracts: A Simplified Explanation
Futures Contracts are simply agreements to buy or sell a specific asset (commodity, currency, stocks, etc.) at a specified price on a future date.
Imagine it as agreeing today to buy a specific commodity, such as a barrel of oil, not at today's price, but at a price you agree on now, with delivery and payment to occur later (for example, after 3 months).
Here is a simplified breakdown of the concept:
Contract Parties
* Seller: Promises to sell the asset in the future at the agreed-upon price.
* Buyer: Promises to buy the asset in the future at the agreed-upon price.
Contract Components
* Underlying Asset: This is the commodity or financial instrument that is agreed to be sold or purchased (for example: gold, oil, wheat, stock index, a specific currency).
* Strike Price (or Futures Price): This is the price set today for completing the transaction in the future.
* Delivery Date (or Expiration Date): This is the future date when the buying and selling must occur.
* Contract Size: Defines the standard quantity of the asset agreed upon in a single contract (for example: 100 barrels of oil, 5000 bushels of wheat).
Why use futures contracts?
Futures contracts are primarily used for two main purposes:
* Hedging:
used by producers and consumers to protect themselves from price fluctuations. For example:
* A wheat farmer can sell futures contracts on his future crop today at a certain price to ensure a stable income, regardless of falling wheat prices at harvest time.
* An airline can buy futures contracts on jet fuel to lock in future fuel costs, protecting itself from rising oil prices.
* Speculation:
used by investors who expect certain price movements. If you expect oil prices to rise in the future, you can buy a futures contract for oil today at a low price, and then sell it later at a higher price if your expectations materialize to make a profit. The opposite is true if you expect prices to fall.
How do futures contracts work?
* Obligation: When you enter into a futures contract, you are legally obligated to complete the transaction on the delivery date, regardless of the market price of the asset at that time.
* Settlement: On the delivery date, settlement can occur in two ways:
* Physical Delivery: The underlying asset is exchanged (for example, a wheat seller delivers wheat to the buyer).
* Cash Settlement: This is the most common method, where the asset is not actually exchanged, but the cash difference between the agreed price in the contract and the current market price of the asset is paid.
A simple example:
Let's say you expect the price of gold to rise in the coming months. You can buy a futures contract for gold today at a price of $2000 per ounce, with a delivery date in 3 months.
* If the price of gold rises after 3 months to $2100 per ounce: You will buy gold at the agreed price of $2000, and you can immediately sell it in the market at $2100, making a profit of $100 per ounce (before fees).
* If the price of gold falls after 3 months to $1900 per ounce: You will still be obligated to buy gold at $2000, while its market price is $1900, meaning you will lose $100 per ounce.
Important Points
* Leverage: Futures contracts allow the use of leverage, meaning you can control a large value of assets with a relatively small investment. This increases potential profits but also increases potential risks and losses.
* Organized Markets: Futures contracts are traded on organized exchanges (such as the Chicago Mercantile Exchange CME), providing transparency $BTC
