What is a futures contract?
A futures contract is an agreement to purchase or sell a specified quantity of a commodity or financial instrument at a specified price on a future date. To help you understand why businesses and individuals trade futures, let’s look at how futures contracts can be used, the major components of a contract, and the fees associated with trading futures. A futures contract can be used to help a business or individual manage risk and uncertainty. Prices are constantly fluctuating, but with a futures contract, investors may lock in a fixed price for future purchases or sales.
How does a futures contract work?
By securing a price, the danger of being negatively impacted by a price change is reduced. Consider how this could work in practice for businesses using the coffee industry as an example.
If the price of coffee beans decreases, it benefits coffee shops but hurts coffee producers. However, if the price of coffee beans increases, the situation reverses.
Coffee bean futures enable both producers and consumers to lock in prices in advance. Now consider how this would function in practice for individuals.
Assume you’re seeking to purchase a new home within the next year and are concerned that interest rates may rise, increasing your mortgage payment. By trading interest rate futures, such as Government Bonds, you can hedge against a prospective interest rate hike.
Futures contracts are also used to enable traders to speculate on the price movement of commodities, currencies, stock market indices, and other assets. Consider the price variations of a commodity such as gold.
A futures trader may profit by properly predicting the direction in which the gold price will move. However, if the futures trader makes an incorrect guess, he or she may lose the entire investment and more.
Now that you understand how a futures contract is employed, let’s take a look at five critical contract components.
Additionally, these are referred to as standard contract specifications.
5 components of futures contracts
- Trading Hours:
Futures markets are open virtually 24 hours per day, 6 days per week; however, each product has its own unique trading hours. - Tick Size:
Tick size is the minimum price increment a particular contract can fluctuate. Tick sizes and values vary from contract to contract. - Contract size:
Each commodity or financial instrument has a standardized contract size that doesn’t change. For example, one contract of crude oil always represents 1,000 barrels. One contract of gold futures represents 100 troy ounces. - Contract Value:
Another component is contract value, which is also known as notional value. This is the current market value of the commodity represented in a futures contract. To calculate this, multiply the size of the contract by the current price. - Delivery:
Contracts are either financially settled or physically settled. Financially settled futures contracts expire directly into cash at expiration. Physically settled futures contracts expire directly into the physical commodity. This includes products like crude oil. For example, anyone long a contract in crude oil at expiration will receive 1,000 barrels of crude oil.
However, don’t be worried about 1,000 barrels showing up at your front door. South African Futures Exchange (SAFEX) does NOT allow clients to take physical delivery, you are required to close the position before the delivery date, and if you don’t, it’ll be closed for you by your Broker. You can find more information about contract specifications on the JSE website.
Now, to understand how much it costs to trade this contract, let’s look at an example. Suppose a crude oil futures contract is trading at R50.00. At this price, 1,000 barrels of crude oil would cost R50,000.00.
However, a trader doesn’t actually have to come up with this amount. With a futures contract, a trader could control the R50,000.00 worth of crude oil with just a small deposit.
This deposit is called the initial margin requirement, and it refers to the minimum amount of funds a trader needs to enter into this contract.
The initial margin requirement is set by the exchange and subject to change, but in our example, we’ll say that to purchase one crude oil futures contract, the trader had to put up R3,000.00 for margin to control nearly R50,000.00 in oil.
Conclusion
As you can see, futures can allow you to leverage a relatively small amount of capital to control a larger underlying asset. Because of this leverage, small changes in the price of the underlying asset have a much larger impact on the futures contract.
Keep in mind that although leverage allows for strong potential returns, it can also result in significant losses. And if losses are substantial, you will have to add more money to cover losses.
Now you know how futures contracts can be used, what the contract specifications are, and how much a futures contract costs. If you’re interested in investing in futures contracts, it’s important that you expand your investing education before you make investments.
