Futures Contract - Stock Trading Terms Explained

A futures contract is a legally binding agreement between two parties, typically a buyer and a seller, in which they agree to buy or sell a specified underlying asset at a predetermined price on a specific future date. The underlying asset can be anything from commodities such as gold, wheat, and crude oil to financial instruments such as currencies, stocks, and bonds. The contract is standardized, meaning that the quality, quantity, and delivery date of the asset are predetermined and agreed upon by both parties. Futures contracts are traded on organized exchanges, and the parties are obligated to fulfil the terms of the contract on the delivery date. Futures contracts are widely used by traders and investors to hedge against price volatility, speculate on price movements, or gain exposure to a particular asset or market. They are also used by producers and consumers of the underlying asset to manage their price risk and ensure a stable supply or demand of the asset.

Examples of futures contracts include the Chicago Mercantile Exchange's E-mini S&P 500 futures contract, which is based on the value of the Standard & Poor's 500 stock index; the New York Mercantile Exchange's crude oil futures contract, which represents a standardized quantity of crude oil to be delivered at a specific time and place; and the Chicago Board of Trade's corn futures contract, which allows traders to buy or sell a specified quantity of corn at a predetermined price and delivery date.

Futures contracts provide many benefits to traders and investors, including the ability to hedge against price risk, speculate on price movements, and gain exposure to various asset classes and markets. Futures contracts also help to promote price transparency and liquidity in the markets in which they are traded. However, futures trading also involves significant risks, including the potential for significant losses due to price volatility and leverage. It is important for traders and investors to understand the risks and benefits of futures trading and to develop a sound trading strategy before entering the market.

Futures contracts can be settled in one of two ways: either through physical delivery of the underlying asset on the delivery date or through a cash settlement based on the difference between the contract price and the market price of the underlying asset at the expiration of the contract. The settlement method is specified in the contract and can vary depending on the underlying asset and the exchange on which the contract is traded.

In addition, futures contracts are traded on margin, which means that traders and investors are required to deposit an initial margin with their broker in order to open a position in a futures contract. The margin amount is typically a percentage of the total contract value and serves as collateral against any potential losses. As the price of the underlying asset changes, the value of the trader's position also changes, and the margin amount may need to be adjusted to maintain the required margin level.

Futures contracts play a significant role in global financial markets, providing a means for participants to manage risk, gain exposure to various asset classes, and trade on price movements. However, trading futures requires a thorough understanding of the underlying assets, market dynamics, and trading strategies, and should be approached with caution by inexperienced traders.