Futures contracts are financial assets just like stocks and bonds, but with some important differences. These differences are what make futures such an appealing investment for traders.
What is a Futures Contract?
A commodity futures contract is a firm commitment to deliver or receive a specific quantity and quality of a commodity during a designated month at a price determined by open auction on a futures exchange.
You can buy a futures contract on gold, silver, copper, zinc, crude oil, live cattle, lumber, pork bellies, orange juice, corn, wheat and many other items. The underlying item or commodity is described specifically in the contract specifications which are determined by the futures exchange on which it trades. The price of a futures transaction is agreed upon initially between the buyer and seller, and remains fixed over the holding period, or length of the contract. The small amount of money that you need to deposit for buyers and sellers of a futures contract is called margin. Finally, the full price of the commodity must be paid only upon contract expiration at which point you take delivery, if you bought futures, or make delivery, if you sold futures, of the underlying commodity. Don't worry. You don't have to make or take delivery if you don't want to. You can instead offset or square yourposition prior to the contract's expiration.
Understanding a Futures Price
When you buy a futures contract, the price represents the price at which you are committed to buying the underlying commodity when the futures contract expires. Similarly, when you sell a futures contract, the price represents the price at which you are committed to selling the underlying commodity when the futures contract expires. (Not all futures contracts require physical delivery upon expiration, some are simply settled by cash.) For example, if you buy a COMEX December gold futures at $880 per ounce, then you have the obligation to buy 100 ounces of gold at a price of $880 per ounce in December when the futures expires. (COMEX, which stands for the Commodities Exchange in New York, is the futures exchange on which gold futures trade. COMEX has set the quantity of gold underlying the contract at 100 ounces.)
The price of gold futures constantly fluctuates in response to several factors such as supply and demand, interest rates, and prices of other precious metals. However, no matter what the price of gold does after you buy the futures, you will be able to buy gold at the price of $880 per ounce - you have locked in this purchase price.
Futures as an Investment
When you buy a futures, you lock in a purchase price for the underlying commodity. Similarly, when you sell a futures, you lock in a selling price of the underlying commodity. If prices go up after you buy a futures contract, then you earn profit since the futures contract has increased in value. For example, if you buy one gold futures at $840 per ounce and two weeks later, the price of gold futures is trading at $850 per ounce, then your futures contract is now worth $10 per ounce more than when you bought it. One futures contract represents 100 ounces of gold, so the total profit on your gold futures position is $1,000. That's the thrill. Be careful, though. Gold prices could have fallen instead.
Margin
Futures contracts are highly leveraged instruments. This is what makes them an appealing investment, and also a risky one. Leverage means that you need only commit a little money to control a lot of product.
Because a little money controls a lot of product, you can get a "big bang for your buck", or a "big bust for your buck". Net profit or loss can quickly become significant relevant to your initial margin. This can, in turn, make you very rich or very poor in a short space of time. Lack of control of leverage is the single leading cause of financial death among beginning futures traders because most tend to "bite off more than they can chew".It is important, therefore, to control leverage.
Volume and Open Interest
Volume and open interest are measures to determine the liquidity of a futures market - the more liquid a market, the faster and easier that trades can be executed. Volume is a running count of the number of futures contracts traded during the day. It is the number of futures contracts that have changed hands. Open interest is the number of futures contracts outstanding, that is, that have not been closed or offset. Official volume and open interest figures are calculated and disseminated by futures exchanges at the end of the trading day, and usually printed in newspapers along with futures prices.
Price Limits
Some futures markets have daily price limits that restrict prices from moving by more than a prescribed amount from the previous day's settlement price. These limits are determined by the futures exchange (with Commodity Futures Trading Commission approval) on the basis of variations experienced in the underlying cash markets, and are meant to serve as circuit-breakers when trading becomes especially volatile. If prices reach the upper or lower limit, trading is suspended for a period of time, referred to as the cooling off period, that may last anywhere from several minutes to the remainder of the trading day. The cooling off period helps to discourage panic buying or selling. Following this period, price limits are usually expanded and trading may resume. Price limits are adjusted from time to time as price volatility changes. In some commodities, the nearby contract month trades without limits for a short period before its expiration. It is important to be aware of the existence of any price limits for the futures contracts that you trade as trades may be difficult or impossible to execute if prices move to the limit and stay there - a condition referred to as locked-limit. You can find this information in the contract specifications.
THE RISK OF LOSS IN TRADING COMMODITY CONTRACTS CAN BE SUBSTANTIAL. YOU SHOULD, THEREFORE, CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. FUTURES AND OPTIONS TRADING IS NOT SUITABLE FOR EVERYONE.
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