An arrangement between two parties to sell and buy a particular item in a preset quantity and at a predetermined price at a future date is called a Futures Contract.
Because future contracts draw their value from an underlying asset, it is also known as a derivative. An investor intends to profit from a rise in the underlying asset’s value by acquiring the right to purchase. Conversely, the investor hopes to benefit from a drop in the underlying asset’s value by accepting the right to sell.
A futures contract’s underlying asset may be one of the following: commodities, equities, currencies, interest rates, or bonds. A reputable stock exchange is where the futures contract is kept. The interaction between the parties serves as a mediator and facilitator. The deal requires both parties to deposit an initial nominal account as part of the contract, known as the margin.
UNDERSTANDING FUTURES IN STOCK
Futures are mostly used in the financial industry for speculating and risk management (hedging) purposes.
Hedging in futures: Institutional investors and companies frequently use futures contracts for hedging to reduce a commodity’s future price risk on their business operations or investment portfolio. Futures contracts are bought or sold to receive or deliver the underlying commodity.
Speculating with futures: Futures contracts can typically be bought and sold up until expiration because they are generally liquid. This is crucial for speculative investors and traders who still need to own the underlying commodity or want to. They can purchase or sell futures to express a viewpoint on—and maybe profit from—the market movement for an item. Then, to release themselves from any responsibility to the actual commodity, they will sell or buy an offsetting futures contract position before expiration.
Why trade futures?
- LEVERAGE- Futures contracts typically require an initial margin requirement that ranges from 3 to 10% of the value of the underlying contract. This leverage increases your potential for greater profits but also the possibility that you will lose more money than you initially invested.
- DIVERSIFICATION- There are a few strategies to diversify your investments with futures that are impossible with equities or ETFs. Unlike secondary market instruments like equities, they can provide direct market exposure to the underlying commodities assets.
- TAX BENEFITS- Compared to other short-term trading marketplaces, futures can offer a possible tax benefit. This is due to the 60/40 split in taxes applied to profitable futures trades: 60% of profits are taxed as long-term capital gains and 40% as regular income.
Futures may also be used if you seek methods to reduce the risk associated with potentially market-moving events.
For example, individual investors and traders use futures most frequently to forecast changes in the underlying asset’s price in the future. They try to make money by making predictions movement of the market for a specific commodity, index, or financial product.
Additionally, some investors use futures as a hedge, typically to decrease the impact on their portfolio or business of likely future market changes in a particular commodity.