What is Futures?
In futures trading, a contract is established to buy or sell a certain underlying asset at a pre-decided price on a future date. This underlying asset can be a commodity, a security (like a stock or bond), or another financial instrument. The key feature is that both buyer and seller are bound to fulfill the contract at the price they agreed upon, regardless of the price of the market at the expiry date, which is the designated settlement date.
How Futures Works
A futures contract is a systematized agreement traded on an exchange, locking in the price of a commodity, security, or financial instrument for a future delivery date. One way to use them is to speculate on price movements. If you believe the price of oil will go up in the future. You can purchase a futures contract that locks in today's price for oil delivery at a later date. If your prediction is right and the price rises, you can sell your contract at a profit. This works the other way too. If you think the price will fall, you can enter a contract to sell oil at a future date, profiting if the price goes down.
Futures contracts are also valuable for businesses that deal with commodities like oil or wheat. These businesses can use them to hedge against price fluctuations. For instance, an airline worried about rising fuel costs can buy oil futures contracts. This locks in a predictable price for oil, protecting them from unexpected price spikes.
Here's what makes futures contracts even more interesting. You don't actually need to own the underlying asset when you buy a futures contract. This means you can assume price movements without taking ownership until the expiration date.
You only need to put up a deposit, called a margin, to enter a futures contract. This allows for leverage, which means you can potentially make bigger profits. You're not stuck with a contract until the expiry date. You can close your position before then to sidestep taking delivery of the underlying asset or to manage your risk.
Difference Between Futures and Options
Futures and options trading differ significantly in terms of the burdens they impose on individuals. A futures contract obligates the investor to execute the trade on a predetermined date at a set price. In contrast, an options contract grants the investor the right, but he is not bound to sell or purchase the underlying security at a specified price, allowing them to proceed only if the trade is profitable.