What are Futures?

by Investing School on January 18, 2012

A future is a financial contract which requires the buyer to purchase an asset at a previously determined date and price. The asset may by an actual commodity or a financial instrument. All the details are defined within the contract, including the quality and quantity of the assets, making the transaction standardized and simpler to understand. How the contract is settled depends upon the agreement and may involve a physical asset or cash.

The key difference between options and futures is that in an option the buyer has the choice, or right, to make the purchase but isn’t required to do so. With a futures contract, the holder is obligated to fulfill the terms of the contract.

The futures market is characterized by individuals who want to hedge or speculate on the price movement of the underlying asset. The goal of the contract is to minimize the risk to both buyer and seller. To minimize credit risk, traders must post a margin – an initial amount of cash, typically 5%-15% of the contract’s value – and the trades are regulated by a clearing house.

It is actually rare for the goods mentioned in a futures contract to actually change hands between the members of the contract. This is the case since hedging and speculation benefits can be enjoyed without holding on to a contract until it expires. Take for example a case where you are long in a futures contract, or in the buying position, you could also go short in a similar contract to balance your position.

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