Understanding Future Contracts: Advantages & Disadvantages
Introducing futures contracts, strong financial mechanisms that define the terms of an asset’s delivery on a future date. They are especially valuable in business because they provide a consistent revenue stream throughout the year and protect against adverse market fluctuations, such as a drop in maize prices. On the other hand, options contracts give the holder the right to buy or sell the underlying asset at any moment before the contract’s expiration date. Unlike options, futures contracts oblige the holder to acquire actual possession of the underlying commodity when it expires. Holders of options and futures contracts stand to benefit from the leverage of the holder’s position if they close it before expiration.
Advantages
Businesses often safeguard themselves against the risks of price fluctuations by hedging the cost of raw materials or products they sell. By leveraging futures contracts, businesses can deposit only a small fraction of the total contract amount with a broker. This not only minimizes their capital requirements but also gives them an opportunity to take speculative positions on the underlying asset’s price direction. Consequently, futures contracts are a reliable tool for managing risks and optimizing investment returns.
Disadvantages
Investing in futures entails the use of leverage, which could lead to potential losses surpassing the initial margin amount. Even hedged corporations could miss out on favorable price fluctuations. While leverage can raise earnings, it can also heighten losses, making it a risky double-edged sword.
How To Use Futures
Futures markets allow traders to use excessive leverage and trade with more than 100% of a contract’s value. Brokers require an initial margin, and the exchange decides whether the deal is for physical delivery or cash settlement. Futures contracts can include speculation, with deals closed and settled in cash. To begin trading, create an account with a broker that offers the desired markets, but note that commission and charge structures vary. Practice with paper money before committing to real funds to understand the interaction with portfolios and fees.
Final Takeaways
Futures contracts can be settled in cash or physical delivery, depending on the underlying asset’s performance. In some cases, physical delivery is necessary, but the investor is responsible for the items and expenses of material handling, storage, and insurance. Practice before entering the real market.
