Futures trading is a very complex and technical subject that many people don’t understand. Despite this lack of understanding, futures contracts are an essential part of the global financial markets as they help manage risk more efficiently than cash instruments. This article is to explore what futures contracts are and how they work and highlight the risks associated with their use.
Defining the key terms
A ‘futures contract’ (or simply ‘contract’) is a standardised legal agreement between two parties to purchase or sell an asset at a specific date in the future for a pre-agreed price. It’s essentially like forward selling/buying. The standardisation allows traders to easily buy and sell contracts without negotiating terms each time with a different counterparty.
A ‘future’ is the most common form of a futures contract typically traded on an exchange such as the CME Group or NYMEX. A future’s value will be based on an underlying asset (such as oil), and this value changes in line with demand for that particular product.
What we mean by ‘risk’ in this context is two things
1: Exposure to changing prices – if the underlying asset’s price goes up or down, the contract holder will make a profit or loss, respectively.
2: Counterparty risk – this is the risk that the other party in the contract (the one you’re selling to/buying from) won’t honour the agreement.
There are a few key reasons why futures contracts are used
- To hedge against price changes
- To take advantage of price differences
- To gain exposure to specific markets
- To manage risk
Let’s look at each of these in more detail
Hedging against price changes is probably the most common reason for using futures contracts. Businesses and individuals can use futures contracts to protect themselves from adverse price movements in the future.
Futures can also be used to take advantage of price differences. If you think that the price of an asset will go up in the future, you can buy a future and sell the asset itself now. It’s called ‘taking a position. If the price does rise as expected, you’ll make a profit on both the contract and the underlying asset. However, if it falls instead, you’ll lose money on both.
Exposure to specific markets is another critical reason why futures are used. By buying a futures contract, you’re not taking ownership of the underlying asset, but you are gaining exposure to it without having to pay for it upfront or store it. It can be beneficial when managing risk in industries with high capital commitments (such as mining), where companies may not know how much they’ll have to spend on resources until after production has started.
Managing risk is the last main point that futures contracts are used for, and perhaps most importantly of all. A financial derivative is essentially a tool for managing risk, allowing an investor to transfer risk from one party to another in return for some form of compensation.
Risks associated with futures contracts
First of all, let’s look at counterparty risk – you’ll only enter into a contract if you trust that your counterparty will be able to fulfil their side of the bargain. However, this isn’t always guaranteed due to significant differences in financial strength between counterparties. The 2008 collapse of Lehman Brothers Holdings is an example of how one company’s failure can impact other companies that deal with them on financial derivatives.
Secondly, although futures allow businesses and individuals to manage specific risks more quickly than they could without them, not all risks can be hedged against using futures contracts alone. You’re always going to have some element of risk when dealing with them.
Another thing to be aware of is that futures contracts can be highly volatile, and prices can move drastically in either direction. It means that they can be risky investments, particularly if you’re not familiar with how they work or the market they’re trading in.
Futures contracts are an essential tool for managing risk, but they should not be considered without due caution. Before investing in them, make sure you understand all the risks involved and that they’re suitable for you.