🎉Futures Contracts are simply agreements to buy or sell a specific asset (commodity, currency, stocks, etc.) at a predetermined price on a future date.

Imagine it as agreeing today to buy a specific commodity, like a barrel of oil, not at today’s price, but at a price you agree on now, with delivery and payment to be made later (e.g., after 3 months).

Here’s a simplified breakdown of the concept:

Contract Parties

* Seller: Commits to selling the asset in the future at the agreed-upon price.

* Buyer: Commits to purchasing the asset in the future at the agreed-upon price.

Contract Components

* Underlying Asset: The commodity or financial instrument that is agreed to be bought or sold (e.g., gold, oil, wheat, stock index, a particular currency).

* Strike Price or Futures Price: The price that is set today to complete the transaction in the future.

* Delivery Date or Expiration Date: The future date on which the sale and purchase must take place.

* Contract Size: Specifies the standard quantity of the asset agreed upon in a single contract (e.g., 100 barrels of oil, 5000 bushels of wheat).

Why use futures contracts?

Futures contracts are primarily used for two main purposes:

* Hedging:

They are used by producers and consumers to protect themselves from price fluctuations. For example:

* A wheat farmer can sell futures contracts on their future crop today at a certain price to ensure a stable income, regardless of a drop in wheat prices at harvest time.

* An airline company can buy futures contracts on jet fuel to lock in the cost of fuel in the future, protecting itself from rising oil prices.

* Speculation:

They are used by investors who expect certain price movements. If you expect the price of oil to rise in the future, you can buy a futures contract for oil today at a low price, then sell it later at a higher price if your expectations are met to make a profit. The opposite is true if you expect prices to fall.

How do futures contracts work?

* Commitment: 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: The most common method, where the underlying 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.

Simple Example:

Suppose 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 to $2100 per ounce after 3 months: You will buy gold at $2000 as agreed in the contract, 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 drops to $1900 per ounce after 3 months: You will still be obligated to buy the gold at $2000, while its market price is $1900, meaning you will lose $100 per ounce.

Important Points

* Leverage: Futures contracts allow for leveraging, meaning you can control a large value of assets with a relatively small capital investment. This increases potential profits but also increases risks and potential losses.

* Organized Markets: Futures contracts are traded on organized exchanges (like the Chicago Mercantile Exchange CME), providing transparency.