There are many advantages and disadvantages of future contracts. The most common advantages include easy pricing, high liquidity, and risk hedging.3 min read updated on February 01, 2023
There are many advantages and disadvantages of future contracts. The most common advantages include easy pricing, high liquidity, and risk hedging. The major disadvantages include no control over future events, price fluctuations, and the potential reduction in asset prices as the expiration date approaches.
What Are Future Contracts?
Future contracts refer to contracts involving predicted future values of currencies, commodities, and stock market indexes. In case of commodities, a futures contract involves a commitment to deliver or receive a certain amount of a commodity at a future date at a price prevailing at that time. However, the actual delivery rarely takes place in futures contracts; instead they are closed out by paying the price differences.
Popular Futures Choices
- Crops like wheat, corn, and soybeans are popular choices for futures contracts. Other popular agricultural products include orange juice and oranges.
- Oil, gas, and coal are popular trading commodities in the natural resource segment.
- Forex or foreign currency trading has gained enormous popularity in future contracts.
- Interest rates are also an option for future contracts.
The Advantages of Future Contracts
Opens the Markets to Investors
Futures contracts are useful for risk-tolerant investors. Investors get to participate in markets they would otherwise not have access to.
Stable Margin Requirements
Margin requirements for most of the commodities and currencies are well-established in the futures market. Thus, a trader knows how much margin he should put up in a contract.
No Time Decay Involved
In options, the value of assets declines over time and severely reduces the profitability for the trader. This is known as time decay. A futures trader does not have to worry about time decay.
High Liquidity
Most of the futures markets offer high liquidity, especially in case of currencies, indexes, and commonly traded commodities. This allows traders to enter and exit the market when they wish to.
Simple Pricing
Unlike the extremely difficult Black-Scholes Model-based options pricing, futures pricing is quite easy to understand. It's usually based on the cost-of-carry model, under which the futures price is determined by adding the cost of carrying to the spot price of the asset.
Protection Against Price Fluctuations
Forward contracts are used as a hedging tool in industries with high level of price fluctuations. For example, farmers use these contracts to protect themselves against the risk of drop in crop prices.
Say for instance a farmer is planting wheat, and she expects to harvest 8,000 bushels of wheat when the crop is ready. Unsure of the prices at the time of harvest, she can sell the entire crop at a fixed price well before the actual harvest, with delivery to be made at a future date such as five months from the date of agreement.
Although the farmer does not get the sale proceeds at the time of the agreement, the transaction offers her protection against any possible fluctuations in currency exchange rates and price drops in the wheat market.
Hedging Against Future Risks
Many people enter into forward contracts for better risk management. Companies often use these contracts to limit risk that may arise from foreign currency exchange.
Let's say for example, a U.S.-based company incurs labor and manufacturing costs in dollars but exports its final products to the European market and receives payment in Euros. The company supplies goods at a lead time of six months, which exposes it to the risk of exchange rate fluctuations. To avoid this risk, the company can use a forward contract to sell its goods at today's exchange rate although the delivery is to be made after six months.
The Disadvantages of Futures Contracts
No Control Over Future Events
One common drawback of investing in futures trading is that you don't have any control over future events. Natural disasters, unexpected weather conditions, political issues, etc. can completely disrupt the estimated demand-supply equilibrium.
Leverage Issues
High leverage can result in rapid fluctuations of futures prices. The prices can go up and down daily or even within minutes.
Expiration Dates
Future contracts involve a certain expiration date. The contracted prices for the given assets can become less attractive as the expiration date comes nearer. Due to this, sometimes, a futures contract may even expire as a worthless investment.
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