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

FAQs

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

They permit the owner as well as that writer to either purchase or sell a respective stock/commodity at a predetermined date and rate in the future. Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging.

The Bottom Line. As an investment tool, futures contracts offer the advantage of price speculation and risk mitigation against potential market downturns. However, they come with some drawbacks. Taking a contrary position when hedging could lead to additional losses if market predictions are off.

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.

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.

Narrator: One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. 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.

Futures are derivative contracts to buy or sell an asset at a future date at an agreed-upon price. Futures contracts allow players to secure a specific price and protect against future price swings. You can buy futures on commodities like coffee, stock indexes like the S&P 500 or cryptocurrencies like Bitcoin.

How much does it cost to trade futures? Fees for futures and futures options are $2.25¹ per contract, plus exchange and regulatory fees, and you pay the same commission whether you trade online or with the help of a broker. Note: Exchange fees may vary by exchange and by product.

High Risk: Commodity futures trading can be exceptionally risky due to the potential for substantial price fluctuations. Losses can exceed the initial investment.

What would be one of the major advantage of futures contracts? ›

Low Execution Cost

To own a futures contract, an investor only has to put up a small fraction of the value of the contract (usually around 10%) as margin. The margin required to hold a futures contract is therefore small and if he has predicted the market movement correctly, he receives huge profits.

Shorting requires us to sell first and buy later. The short trade is profitable only when the closing price is lower than the entry price. There would be a loss when the price goes higher than the price at which one has shorted. The stop loss in a short trade is always higher than the price at which one has shorted.

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.

Lack of a clear strategy: Options trading requires a well-defined strategy. If options buyers do not have a clear plan, exit strategy or risk management in place, they may make impulsive decisions that lead to losses.

Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.

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.