Futures contracts are a type of derivative that allows investors to buy or sell an underlying asset at a predetermined price on a future date. In this article, we will provide a comprehensive guide to understanding and valuing futures contracts, including what they are, how they work, and the tools you need to successfully trade these derivatives.
What are Futures Contracts?
A futures contract is a legal agreement between a buyer and a seller to buy or sell an underlying asset at a predetermined price on a future date. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. Futures contracts are traded on a wide range of commodities, currencies, interest rates, and indexes, and they are a huge part of the financial industry. More than 29 billion futures contracts were traded in 2021, according to data from the Futures Industry Association (FIA).
How Do Futures Contracts Work?
Futures contracts work by creating an agreement between a buyer and a seller to exchange a certain asset or instrument on a date in the future for a predetermined price. The buyer of a futures contract agrees to buy the underlying asset at a predetermined price on a future date, while the seller agrees to sell the underlying asset at a predetermined price on a future date.Futures contracts are settled on a daily basis, which means that the gains or losses from the contract are settled each day. This is known as marking to market. Futures contracts can be used for speculation or hedging. Speculators use futures contracts to profit from the price movements of the underlying asset, while hedgers use futures contracts to protect themselves against price fluctuations.
Types of Futures Contracts
There are many different types of futures contracts available. These may have underlying assets such as oil, stock market indices, currencies, and agricultural products. Some of the most popular types of futures contracts include:
Commodity Futures: These are futures contracts that are based on commodities such as gold, silver, oil, and wheat.
Currency Futures: These are futures contracts that are based on currencies such as the US dollar, euro, and Japanese yen.
Stock Index Futures: These are futures contracts that are based on stock market indices such as the S&P 500, Dow Jones Industrial Average, and Nasdaq.
Valuing Futures Contracts
The value of a futures contract is determined by the price of the underlying asset and the contract’s expiration date. The price of a futures contract is quoted in points, with each point representing a certain amount of money. The value of a futures contract can be calculated by multiplying the price per point by the number of points in the contract.
Advantages of Futures Contracts
Leverage: Futures contracts allow investors to control a large amount of an underlying asset with a relatively small investment. This can amplify profits if the trade goes in the investor’s favor.
Hedging: Futures contracts can be used to hedge against price fluctuations in the underlying asset. This can help investors protect themselves against losses.
Liquidity: Futures contracts are highly liquid, which means that investors can easily enter and exit positions.
Disadvantages of Futures Contracts
Risk: Futures contracts are highly leveraged, which means that a small price movement in the underlying asset can result in a large gain or loss.
Expiry Dates: Futures contracts have expiry dates, which can present challenges for investors who are holding positions for the long term.
Complexity: Futures contracts can be complex and require a substantial investment of time and energy to understand.
Futures Trading Strategies
There are many different strategies that investors can use when trading futures contracts. Here are some of the most popular strategies:
Trend Following: This strategy involves identifying trends in the market and following them. You can use technical analysis tools like moving averages and trend lines to identify trends.
Breakout Trading: This strategy involves identifying key levels of support and resistance and entering trades when the price breaks through these levels.
Spread Trading: This strategy involves taking advantage of price differences between two or more futures contracts. For example, you might buy a contract for a commodity in one market and sell a contract for the same commodity in another market.
Tips for Futures Trading
Here are some additional tips for understanding and valuing futures contracts:
Learn about futures: Futures trading requires specialized knowledge. There are several online courses available for beginners that teach the ins and outs of futures trading.
Focus on a few markets: Don’t spread yourself too thin by trying to follow and trade too many markets. Focus on a few markets that you understand well.
Stay informed: Futures trading requires a substantial investment of time and energy. Stay informed by studying charts, reading market commentary, and staying on top of the news.
Use stop-loss orders: Stop-loss orders can help you limit your losses if the trade goes against you.
Understand the risks: Futures trading can be risky, and it’s important to understand the risks before you start trading. Make sure you understand the risks associated with leverage, expiry dates, and market volatility.
Conclusion
In conclusion, futures contracts can be a lucrative way to invest, but they require a solid strategy and a lot of hard work. By following the tips and strategies outlined in this article, you can successfully understand and value futures contracts and maximize your profits.
