Futures contracts were created for producers and consumers of certain goods to protect themselves against future price changes. So, if two people want to bet on the future prices of those goods, they enter into a contract that specifies that one person will buy or sell that good at a pre-determined price in the future.
The first party has gained protection from falling prices while the other party has gained protection from rising prices; thus, both parties can predict their risk when making production/consumption decisions today. This concept remains true regardless of whether the party is a producer or consumer.
Table of Contents
Sell/buy for profit
This strategy is beneficial for those who are not planning on taking possession of the good anytime soon. Sellers bet that future prices will be lower than current prices, while buyers bet future prices will be higher. When you sell futures contracts, you don’t ever have to take possession of goods if they fall in price.
But if they rise in price, you still have to honour your contract and purchase the good at the pre-determined price. On the other hand, when you buy product futures contracts, you never actually get delivery of the commodity – instead, you just offset your position by selling an equal number of contracts later (hopefully at a higher price).
If it turns out that prices fell, you can walk away and leave the contract unfilled.
Use contracts as leverage for other investments
Selling futures contracts short is another popular way to use them for financial gain. Short selling allows you to profit from falling prices without actually owning any of the resources in question.
You borrow a set of contracts (usually, each contract represents 1 unit of the good) from long-term holders who want to sell but are waiting for higher prices. You then sell them on the market, collecting immediate profit with no risk of losing your original capital investment if it turns out that future prices rise instead.
If prices were to fall as anticipated, you could buy back some or all of your contracts at a lower price, return them to the original holders, and keep your profits.
Hedge against risks
Futures contracts are also popular to provide insurance against certain risks. For example, if you’re planning on producing goods that depend on the future price of oil, it might be helpful to purchase oil futures at today’s prices to lock in an acceptable sales price. Futures can also be used as an effective way of shedding off some risk when there is too much exposure to them.
You may even seek out markets where volatility has historically been low so that you have less chance for losses due to daily fluctuations in price. But remember: although futures protect producers from falling prices or buyers from rising prices, they don’t protect you from sharp price movements that leave you with losses.
Suppose you’re planning on using futures for hedging against risk. In that case, it’s essential to choose a suitable variety of futures contracts (the same kind as your underlying asset) and manage your position well by establishing a stop-loss order in advance.
Speculation with leverage
Speculating with futures contracts is another popular strategy in today’s market because of how much leverage it provides. It allows investors to take significant positions and high risks without spending too much money upfront.
When you speculate with futures, instead of waiting to buy or sell until settlement day, you can just offset your position the next time that the futures contract “matures” (i.e. every month, quarter, or year).
If you want to speculate with long-term contracts, you can put in a stop-loss order to close your position if prices drop too low.
One potential problem of this strategy is that it’s dependent on what happens next – if prices rise beyond your expectations, you lose out on profit because you already offset your position. However, if prices fall lower than expected, you will still have to honour all of your outstanding contracts.
