The futures market is a financial market where contracts are bought and sold to deliver a commodity or financial instrument at a fixed date in the future. Futures markets can be used to hedge risk, but also can be used for speculative purposes.
Let’s deepen the topic and discover more about the futures market.
Table of contents
- What is futures market
- How does futures market work?
- Advantages of futures market
- Disadvantages of futures market
What is futures market
A futures market is an exchange where contracts for future delivery of a commodity or security are traded. The delivery date and price are specified in advance, and the buyer and seller agree to transact at that price on that date.
Futures contracts are standardized so that each contract represents a specific quantity of the underlying asset. And, because both parties guarantee delivery, futures contracts are “cash-settled“. That means no actual delivery of the underlying asset takes place; instead, cash changes hands based on the difference between the contract’s agreed-upon price and the actual market price at expiration.
The most important function of a futures market is to provide price discovery and allow participants to manage risk. In a properly functioning futures market, prices will reflect all available information about a particular commodity or security—including supply and demand fundamentals, as well as other factors such as weather or geopolitical events. This information is constantly being integrated into prices through the actions of buyers and sellers in the market. And because participants can use futures contracts to hedge their positions, these markets also play an important role in managing risk. By hedging, market participants can protect themselves from unfavorable movements in prices.
For example, a farmer might enter into a corn futures contract in order to lock in a price for his crop before it is even planted. In this way, he reduces his exposure to the risk of a decline in corn prices. Similarly, an airline might use fuel futures contracts to hedge against rising fuel costs. By doing so, the airline can protect itself from sharp increases in fuel prices that could eat into profits.
How does futures market work?
Futures contracts are traded on commodities exchanges around the world.
The prices of futures contracts are based on the prices of the underlying commodities in the spot market. The price of a futures contract is usually higher than the spot price because it includes the cost of carrying or storing the commodity until delivery. In most cases, participants in the futures market do not actually take delivery of the underlying commodity but instead close out their positions before maturity by entering into offsetting transactions.
Because future prices can be influenced by factors such as weather, interest rates, and political events, they can be very volatile.
Advantages of futures market
The futures market is a great way to hedge against risk and protect your portfolio from unforeseen events. This can be helpful if you anticipate that the price of the asset will go up in the future, as it allows you to lock in a lower price today.
Futures can also be used to speculate on the future direction of markets. If you think that the price of oil is going to rise, for example, you can buy a futures contract and make a profit if your prediction comes true.
Finally, futures can be used to add diversification to your portfolio. By investing in multiple asset classes, you can minimize your exposure to any one particular market or economic event.
Disadvantages of futures market
A disadvantage of futures contracts is that they are complex financial instruments. Unlike stocks or bonds, which are relatively simple to understand, futures contracts involve a great deal of leverage and margin requirements. As such, they are often considered to be high-risk investments.
In addition, the fees associated with trading futures contracts can be quite high.
Another potential drawback is that futures prices are highly volatile. This means that there is a greater potential for loss, especially if an investor does not correctly predict the direction of the market.
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Disclaimer: these articles are for educational purposes only. Market analysis, prices, news, trade ideas, or any other information within this site or the chatroom is not investment advice.