What is a Futures Contract?

Imagine you’re a time traveler from the year 2023, and you know the price of corn in 2024. You can use this knowledge to make a bet with a farmer that the price of corn will be higher or lower than your prediction. This bet is called a futures contract.

A futures contract is an agreement to buy or sell a specific amount of a commodity, currency, or financial instrument at a predetermined price on a future date. The contract is standardized and traded on a futures exchange, which is a regulated marketplace for these types of transactions.

The buyer of a futures contract agrees to purchase the underlying asset at the agreed-upon price on the specified date, regardless of the market price at that time. The seller of a futures contract agrees to deliver the underlying asset to the buyer at the agreed-upon price on the specified date, regardless of the market price at that time.

Futures contracts are used for a variety of purposes, including:

Hedging: Farmers and other producers can use futures contracts to lock in a price for their products, protecting themselves against potential price fluctuations.

Speculation: Traders can use futures contracts to bet on the future price of a commodity or other asset.

Arbitrage: Traders can use futures contracts to profit from price differences between different markets.

What is the Impact of Futures Contract Expiration on Premium and Settlement?

As a futures contract approaches its expiration date, its premium, which is the difference between the contract price and the spot price of the underlying asset, will typically decline. This is because the contract is becoming less valuable as the delivery date approaches.

On the expiration date, the futures contract is either settled or exercised. Settlement occurs when the buyer and seller agree to exchange the underlying asset for the agreed-upon price. Exercise occurs when the buyer or seller takes physical delivery of the underlying asset.

The settlement price of a futures contract is typically based on the spot price of the underlying asset on the expiration date. If the futures contract price is higher than the spot price, the buyer will have to pay the seller the difference. If the futures contract price is lower than the spot price, the seller will have to pay the buyer the difference.

What Factors Affect the Premium of a Futures Contract?

The premium of a futures contract is affected by a number of factors, including:

The spot price of the underlying asset: The premium will typically be higher when the spot price is volatile.

The time to expiration: The premium will typically decline as the expiration date approaches.

The interest rate: The premium will typically be higher when interest rates are high.

The supply and demand for the underlying asset: The premium will typically be higher when the supply is low or the demand is high.

What are the Risks of Trading Futures Contracts?

There are a number of risks associated with trading futures contracts, including:

Price risk: The price of the underlying asset can fluctuate, which can lead to losses.

Settlement risk: The buyer or seller may not be able to fulfill their obligations under the contract, which can lead to losses.

Margin calls: Futures contracts require the use of margin, which is a deposit that the trader must maintain to cover potential losses. If the trader’s account balance falls below the required margin, the trader may be forced to sell their contracts at a loss.

How Can I Avoid the Risks of Trading Futures Contracts?

There are a number of ways to avoid the risks of trading futures contracts, including:

Educate yourself: Before you start trading futures contracts, it is important to educate yourself about the risks involved.

Trade with a small amount of money: When you first start trading, it is important to trade with a small amount of money that you can afford to lose.

Use stop-loss orders: A stop-loss order is an order to sell your contract if the price of the underlying asset falls below a certain level. This can help you limit your losses.

Monitor your account balance: It is important to monitor your account balance regularly to ensure that you have enough margin to cover potential losses.

Futures contracts can be a valuable tool for hedging, speculation, and arbitrage. However, it is important to understand the risks involved before you start trading futures contracts. By educating yourself, trading with a small amount of money, using stop-loss orders, and monitoring your account balance, you can help to reduce your risk of losses.

What are your thoughts on futures contracts? Do you think they are a good investment?