What is a Futures Contract and how does it work?

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27-Apr-2020 10:48:28
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Futures Contracts

What is a Future Contract?

A Futures contract is a legally binding agreement to buy or sell an asset at a future date at a pre-determined price.

Businesses use Futures contracts to lock in a fixed price for raw materials such as Oil/Wheat/Corn, etc. Farmers use them to secure buyers at a fixed price for their produce. Futures contracts are a blessing, especially for farmers who produce perishable crops(Eg: Onion, Tomato etc..) and for businesses which produce/use goods which require huge storage facilities, e.g. Oil, Natural Gas etc...

Producers, traders and manufacturers use Futures Contracts to secure the sale/purchase and delivery of goods at a specific price. Speculators and investors also use them to profit from the price movements of the commodity. 

Such contracts are facilitated and regulated by Futures Exchanges like the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange.

How it all started?

The Futures contract, as it is known today, evolved as producers and traders/manufacturers agreed to exchange goods and cash at a specific date/month in the future.

For Example; John, a farmer, agreed with Smith, the wholesaler; in January, to deliver 5000 bags of rice after the harvest in April for $1/bag. Such an agreement benefited both John and Smith. John is confident that he had a ready buyer for his produce @ $1/bag, and Smith knows his purchase price in advance, helping him plan his inventory, selling strategy and cash flows.

Upon agreement, Smith paid John, a token advance of $500 to seal the Future contract. 

John is now bound by the contract to deliver 5000 sacks of rice by April to Smith, no matter how good or bad his harvest is. On the other hand, Smith has to pay John, $1/bag and take the delivery 5000 bags of rice irrespective of the prevailing price in the market.

Over some time, such contracts became more common, and even banks started accepting them as collaterals for loans. People also began to buy or sell such agreements before the actual delivery date. 

Continuing from the above example, If Smith decided he didn't want the rice, he would sell the contract to someone who did. Or, if John, didn't want to or could not deliver the rice as agreed, he might pass on his obligation to another farmer. The price of the contract would go up or down, depending on the demand for rice in the market. 

If the harvest were not so good, then the supply would be low, many buyers would be willing to pay more than usual to buy this contract/commodity from Smith. On the other hand, if the harvest were better than expected, many sellers would be happy to buy this contract from John to supply at a pre-determined price. 

Slowly but steadily, people who had no intention of ever buying or selling a particular commodity started trading these contracts. They were the speculators who were hoping to benefit from the price movements of a commodity. 

Should I invest in Futures Contracts?

Like every other investment, Futures Contracts can also be a part of your portfolio, depending on your goals, risk appetite and your understanding of such assets. 

Unlike Stocks, Bonds, ETFs and Mutual Funds; Futures Contracts are more complex, volatile and risky. As an investor, you should avoid this asset class unless you understand the nature of such contracts very well, and you intend to speculate.

Moreover, speculation of any kind should not be more than 5.00% of your investment portfolio. 

Holistic Financial Planning

Holistic Financial Planning goes far beyond buying or selling financial products. It helps you identify and align your investments to your life goals. 

Holistic Financial Planning not only helps you set a course of action, but it also helps you stay calm and remain focussed to your goals during volatile market situations.

As an Independent Financial Advisor, I help my clients set up a holistic financial plan at the outset and recommend suitable solutions matching their needs and goals.

I can help you build your financial plan based on your goals and dreams and review it regularly to ensure we are progressing towards achieving them.

Arrange a Free Consultation to set the ball rolling... 

Click Here to Arrange a Free Consultation

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