Futures Contract: Meaning, Definition, Pros & Cons | 5paisa (2024)

FAQs

Futures Contract: Meaning, Definition, Pros & Cons | 5paisa? ›

They permit the owner as well as that writer to either purchase or sell a respective stock/commodity at a predetermined date and rate in the future. Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging.

The Bottom Line. As an investment tool, futures contracts offer the advantage of price speculation and risk mitigation against potential market downturns. However, they come with some drawbacks. Taking a contrary position when hedging could lead to additional losses if market predictions are off.

Definition: A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future. Description: The payment and delivery of the asset is made on the future date termed as delivery date.

Expiration risk: Futures contracts have fixed expiration dates. If you don't close or roll over your position before expiry, you may face delivery obligations or cash settlement at an unfavourable price. Interest rate risk: Interest rate futures are sensitive to changes in interest rates.

A futures contract allows an investor to speculate on the direction of a security, commodity, or financial instrument, either long or short, using leverage. Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price changes.

While futures can pose unique risks for investors, there are several benefits to futures over trading straight stocks. These advantages include greater leverage, lower trading costs, and longer trading hours.

Common risks of F&O trading include: F&O orders can be executed partially or with significant price differences due to liquidity and market volatility. Due to a large difference in the buying and the selling price, orders can be executed at prices far from the Last Traded Price (LTP), increasing impact costs.

You don't have to have the margin in place to buy options on a futures contract, and your loss is limited to the premium no matter what direction the underlying moves. When selling options on a futures contract, your maximum loss is unlimited, while your maximum profit is limited to the premium.

There are two types of people who trade (buy or sell) futures contracts: hedgers and speculators.

Settlement type: Futures contracts can be settled through physical delivery of the underlying asset or cash settlement. For crude oil futures like “CLZ24,” physical delivery is more standard, though many participants close their positions before the delivery date to avoid actual delivery.

How much does a futures contract cost? ›

How much does it cost to trade futures? Fees for futures and futures options are $2.25¹ per contract, plus exchange and regulatory fees, and you pay the same commission whether you trade online or with the help of a broker. Note: Exchange fees may vary by exchange and by product.

Market Risk: The most obvious risk with futures trading is that prices can be highly volatile, and changes are can be swift, adverse, and devastating. 11 This is because the market risk is magnified by leverage, when there's already enough to worry about when supply and demand shift.

Narrator: One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by price change.

Hedging can be an effective way to mitigate risks in trading. However, it is essential to weigh the pros and cons before using this strategy. While it can protect against losses and increase confidence, it can also be costly, limit profit potential, and be a complex strategy to execute.

High Risk: Commodity futures trading can be exceptionally risky due to the potential for substantial price fluctuations. Losses can exceed the initial investment.