Futures Contract: Meaning, Definition, Pros & Cons | 5paisa (2024)

FAQs

Futures Contract: Meaning, Definition, Pros & Cons | 5paisa? ›

Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.

Definition: A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future.

Futures have several advantages over options in the sense that they are often easier to understand and value, have greater margin use, and are often more liquid. Still, futures are themselves more complex than the underlying assets that they track. Be sure to understand all risks involved before trading futures.

The Forward contracts include a high counter party risk and there is also no guarantee of asset settlement till the maturity date. The Futures contract involves a low counterparty risk and the value is based on the market rates and is settled daily with profit and loss.

Yes, it is possible to lose more money than you initially invested in futures trading. This is because futures contracts are leveraged, which means you can control a large position with a relatively small amount of investment upfront. 9 While leverage can amplify your gains, it can also magnify your losses.

Expiration risk: Futures contracts have fixed expiration dates. If you don't close or roll over your position before expiry, you may face delivery obligations or cash settlement at an unfavourable price. Interest rate risk: Interest rate futures are sensitive to changes in interest rates.

Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change. Let's look at how this might work for businesses using the coffee industry as an example.

Futures contracts can be an essential tool for hedging against price volatility. Companies can plan their budgets and protect potential profits against adverse price changes. Futures contracts also have drawbacks. Investors risk losing more than the initial margin amount because of the leverage used in futures.

Unlike investing in shares where you usually buy first and sell later, futures allow you to sell first and buy back later if you desire. This enables you to take advantage of falling prices as well as rising prices. Selling a futures contract is known as being 'short futures'.

Why do people trade futures instead of options? ›

The futures markets provide direct access to trade a variety of products and contracts, both financial and commodities, which are not available through stock option trading. This means that futures can offer greater diversification which can help offset the risk of having all your eggs in one directional basket.

Because futures are highly leveraged, margin calls might come sooner for traders with wrong-way bets, making them potentially a more risky instrument than a stock when markets move fast.

Many factors affect the price of futures, such as interest rates, storage costs, and dividend income. The futures price of a non-dividend-paying and non-storable asset is the function of the risk-free rate, spot price, and time to maturity.

There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC). Forwards have more counterparty risk than futures.

The margin requirement in the futures market implies that trading in the futures market is highly leveraged. A forward contract is not formally regulated, whereas a futures contract is regulated by the stock exchange where the clearance house is situated.

Since forward contracts are also speculative, they can be incredibly risky for the buyer. Future contracts are settled with cash. However, forward contracts are usually settled after the delivery of the asset however cash-settlement is also possible.

Lack of discipline is a major shortcoming.

Trading against the trend, especially without reasonable stops, and insufficient capital to trade with and/or improper money management are major causes of large losses in the futures markets; however, a large capital base alone does not guarantee success.

A negative call price implies that the option writer pays the option purchaser to take the option. In the absence of significant market frictions, negative option prices should not be observed in well-functioning financial markets.

Futures tend to be riskier as they are directly aligned to the asset prices and their volatility. On the other hand, Options react differently to the underlying asset price movements and allow you relatively more time to manoeuvre and curtail losses. Further, the critical difference between Futures vs.

There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC). Forwards have more counterparty risk than futures.