Futures Contract

A futures contract is an agreement concluded between a seller and a buyer on the purchase and sale of an underlying asset in the future. The parties to the agreement make a proviso in advance on at what price and within what period the concluded transaction will take place.

In fact, most futures contracts are used for speculation. You think that the share price of company “N” will rise in the near future, so you purchase futures contracts for these shares. When you think that the stock price is about to fall, you sell this futures contract. Speaking about a futures contract, you need to remember one nuance — the terms “buy-sell” are conditional concepts.

There are types of futures contracts for which you do not even need to hold the shares for which this futures contract was concluded — the settlement may be cash-based rather than physical. Futures contracts are not investments. There is no need to equate the purchase of a futures contract with the purchase of shares.

Let’s define the difference between a futures contract and stocks. By purchasing shares of the company “N” you:

• In fact, if you become a co-owner of the company, a record of your own shares of the company is made in a special depository.
• As a shareholder of the company, you can participate in shareholder meetings in proportion to the share of your shares (stocks).
• You get the right to the company’s profit in the form of dividends.
• You are entitled to a portion of the funds that will be received during the liquidation of its assets in the event of bankruptcy

Types of futures contract:

• Cash-settled futures contract. On the date of execution of the futures contract, a financial settlement of the position takes place (profit or loss fixation).
• Delivery futures contract. On the due date, the purchase/sale of the underlying asset takes place.

Why Futures Trading Is Not an Investment?

You can’t just buy a futures contract and forget about its existence, unlike stocks, since a futures contract is an instrument of a derivatives market, it has its own due date, the date on which all contracts are executed, and the parties record either profit or loss. When using a futures contract, you will not be able to “sit out” the recession.

A futures contract does not have additional capital in the form of dividends or shares climbed.

The Benefits of a Futures Contract

If we compare speculation and futures trading, the latter has their advantages:

• Leverage is inherent, since at the time of the transaction you do not pay the entire value of the asset — a guarantee is sufficient, as a rule, it is about 10% of the transaction.
• There are no restrictions on short-selling. If, purchasing shares, you “borrow” them from a broker to make a profit, then everything is different with futures — they do not physically exist, these are just agreements. Buying and selling futures contracts reflects your position; you are not borrowing securities from anyone. When you participate in stock trading, you return the same shares to the broker. If you borrowed them from a broker, sold them, and then they became cheaper, then you are in the black. The broker takes a percentage for such a “loan” of shares.
• Transactions are cheaper, since futures contracts are standardized derivatives and do not need to be stored in a special vault or pay a depository for storage.

Disadvantages of a Futures Contract

This is an unsuitable financial instrument for long-term and passive investments, since you need to buy a new one every time the contract expires. The limited validity period, on average, is from 9 to 12 months for standard contracts. In addition, there is no passive income in the form of dividends and coupons.

A futures contract is a rather complex financial instrument with its own nuances. The price for a contract is formed very confusingly; the amount of the guarantee may change, besides, mutual settlements, the so-called clearing, take place twice a day on most exchanges.

What to Consider When Trading a Futures Contract

Since a futures contract is a speculative instrument used for short-term transactions, it is important to rely on the price chart and technical indicators when trading. These actions will allow you to predict price dynamics and determine the entry point. You can apply technical analysis at any time interval, whether trading within one day, or following a medium-term trend.

Fundamental analysis allows you to understand the nature of the underlying asset and the growth drivers. A futures contract is a “young” instrument in relation to its underlying asset, and its chart does not always give a complete picture.

How to Make Money on a Futures Contract

• Speculative trading — futures contracts are more convenient than stocks for a trader, they have higher volatility, they are cheaper, and leverage is inherent.
• Hedging — protection of the investment portfolio from drawdown. You have stocks that you want to hold for longer, but at the same time you want to insure against their possible fall. In this case, you open a short position on stock futures. If stock prices decline, then futures compensate for the loss.
• Alternative tools. Due to the fact that the underlying asset in a futures contract is not only stocks, but indices with volatility, commodities such as oil, gas, this allows you to invest in a wide range of instruments and better diversify your investments.

Risks in Futures Trading

• Trading with leverage. Using a futures contract, you can open a position that significantly exceeds the amount in the brokerage account. If something goes wrong, then the loss can be unlimited and you can lose all your capital or make a huge profit, if successful.
• Low liquidity. There may be small volumes of trading on some contracts, and then it is difficult to enter or exit a position at a reasonable price.
• Changing the risk rate. In case of market unrest, the exchange may increase the guarantee. It will not be possible to “sit out” losses, since a futures contract has a short validity period, unlike stocks.