Futures contract definition

What is a futures contract?

A futures contract is a legal agreement between two parties to trade an asset at a predefined price, on a specific date in the future. Futures contracts are traded on exchanges and can be used to gain exposure to a variety of assets, such as commodities or indices. They are commonly referred to as ‘futures’.

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How do futures contracts work?

Futures contracts are standardised to specify the quality and quantity of the underlying asset. When a trader buys a futures contract they are taking on the obligation to buy the underlying asset, at the agreed price, when the futures contract expires. And when a trader sells a futures contract, they would be obliged to sell the asset for the agreed price at the expiration date.

While some futures will require the physical asset itself to change hands, others can be settled in cash. When traders settle in cash, they exchange the price dictated in the contract, which could differ from the market’s current price.

All futures contracts have an expiry date: the date at which the underlying asset has to be delivered in the future. This differs from the ‘spot’ price, which is the price of a market if the trade were to be completed that day.

Commodity producers often use futures contracts to guarantee the price of their product ahead of sale, as they present a way to lock in the price of an asset for the long term, keeping prices stable. But most retail traders buy futures with the intention of selling them again at a higher price and making a profit. They are often used to hedge against other trades, or purely for speculation.

Example of futures contracts

Let’s say you’re interested in trading the DAX, which has a current buy price of $10,700. You believe that if the market breaks the $10,750 price level, it will continue to rise, so decide to use a futures contract to buy at $10,750 in two months’ time.

At the expiry date, if the DAX was trading at $10,770, you could execute your futures contract to buy at the agreed price of $10,750 and take a profit. But, if the market had fallen, or never reached the $10,750 level, you would still have to pay the agreed amount and would suffer a loss.

The size of the profit or loss depends on the number of contracts you traded and the value of each contract per point of movement.

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