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Contracts And Agreements In Forex Trading: Best Practices From Mississippi Attorneys – A futures contract is a legal agreement to buy or sell a certain asset, commodity, or security at a predetermined price at a specified time in the future. Futures contracts are standardized in quality and quantity to facilitate trading on futures exchanges.
The buyer of a futures contract assumes the responsibility of buying and receiving the underlying asset when the futures contract expires. The seller of the futures contract undertakes to supply and deliver the underlying asset at the expiration date.
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Futures are derivative financial contracts that obligate parties to execute an asset at a specified future date and price. Here, the buyer must buy or the seller must sell the underlying asset at a fixed price, regardless of the current market price on the expiration date.
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Fixed assets include physical goods or other financial instruments. Futures contracts specify a quantity of an underlying asset and are standardized to facilitate trading on futures exchanges. The future can be used for hedging or trading speculation.
“Future contract” and “future” refer to the same thing. For example, you may hear someone say they bought an oil future, which means the same thing as an oil futures contract. When someone says “futures contract,” they are usually referring to a specific type of future, such as oil, gold, bonds, or S&P 500 index futures. Futures contracts are also one of the most direct ways to invest in oil. The term “futures” is more general, and is often used to refer to the entire market, as in, “They are a futures trader.”
Futures contracts are standardized, unlike forward contracts. Forwards are similar types of contracts that lock in the future price at the moment, but forwards are sold over the counter (OTC) and have customizable terms that are negotiated between peers. Futures contracts, on the other hand, will each have the same terms regardless of who the counterparty is.
Producers or buyers hedge the underlying asset or security at the price at which the commodity is sold or bought. They use futures contracts to ensure they have a buyer and a reasonable price, preventing any changes in the market.
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An oil producer needs to sell his oil. They can use futures contracts to lock in the price at which they will sell, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need fuel for making documents. Since they like to plan ahead and always have oil coming in every month, they too can use futures contracts. This way they know in advance the price they will pay for oil (future contract price) and they know they will be delivering the oil once the contract expires.
Since most commodity prices tend to move in predictable patterns, it is possible to profit by trading futures, even if one has no direct interest in the underlying commodity. Traders and fund managers use futures to place bets on the price of an underlying asset.
For example, a trader may buy grain futures if he expects the price of grain to rise before the delivery date. Any unexpected changes in weather or growing conditions can cause futures prices to rise or fall.
Futures contracts can be used to set prices for any type of commodity or asset, as long as there is a large enough market for it. Some of the most frequently traded types of futures are listed below:
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A futures contract is similar to a forward contract, where the buyer and seller agree to set a price and quantity for a commodity to be delivered at a later date. Both types of contracts can be used for speculation, including hedges.
However, there are also important differences. While a futures contract is a standardized agreement that can be traded on an exchange, a forward contract is an individual agreement between a buyer and a seller. Although it is possible to trade on the OTC markets, they are unregulated and less accessible to retail investors. This means that there are more opportunities to customize the forward agreement according to the needs of the buyer and seller.
Imagine an oil producer plans to produce one million barrels of oil in the next year. It will be ready to ship in 12 months. Assume the current price is $75 per barrel. A producer can produce that oil, and then sell it at the current market price one year from today.
Given the volatility of oil prices, the market price at that time may be very different from the current price. If an oil producer thinks oil will be higher in a year, they may choose not to lock in the price now. But, if they think $75 is a good price, they can lock in a guaranteed sale price by entering into a futures contract.
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A mathematical model is used to price futures, which takes into account the current spot price, risk-free rate of return, time to maturity, storage costs, dividends, dividend yield, and convenience yield. Assume that one-year oil futures contracts are trading at $78 per barrel. By entering into this contract, in one year the producer is obliged to deliver one million barrels of oil and is guaranteed to receive 78 million dollars. The price of 78 dollars per barrel is received regardless of the market prices of the place at that time.
Contracts are standardized. For example, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. So, if someone wanted to lock the price (sell or buy) on 100,000 barrels of oil, they would need to buy/sell 100 contracts. To lock the price on one million barrels of oil/they would need to buy/sell 1,000 contracts.
Futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market prices, including preventing unfair trading practices, fraud, and regulating brokerage firms engaged in futures trading.
Retail traders and portfolio managers do not like to deliver or receive underlying assets. A retail trader has little need to receive 1,000 barrels of oil, but may be interested in profiting from changes in oil prices.
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Futures contracts can only be traded at a profit, as long as the trade is closed before expiration. Most futures contracts expire on the third Friday of the month, but contracts vary so check the contract specifications of any contracts before trading them.
For example, it’s January, and April contracts are selling for $55. If a trader believes that oil prices will rise before the contract expires in April, they can buy the contract at $55. This gives them control of 1,000 barrels of oil. However, they do not have to pay $55,000 ($55 x 1,000) for this privilege. Instead, the broker only requires a small upfront payment, usually a few thousand dollars per contract.
The profit or loss of a position changes in the account as the price of the futures contract moves. If the loss is too big, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin.
The final profit or loss of the business is realized when the business is closed. In this case, if the buyer sells the contract for $60, they make $5,000 [($60-$55) x 1,000). Otherwise, if the price drops to $50 and they close the position, they will lose $5,000.
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The futures contract got its name from the fact that the buyer and seller of the contract agree on the price today of some asset or security that will be delivered in the future.
These two types of certificate contracts work in a similar way, but the main difference is that futures are traded on an exchange and have standardized contract specifications. These exchanges are highly regulated and provide transparent contract and price data. Forwards, in contrast, trade over the counter (OTC) with the terms and conditions and specifications of the contract customized by the two parties involved.
Unless the position of the contract is closed before its expiration, the short is obliged to make the delivery for the long term, who is obliged to take it. According to the contract, the exchanged values can be settled in cash. In most cases, the trader will simply pay or receive cash payments based on whether the underlying asset increased or decreased during the investment period. In some cases, however, future contracts will require physical delivery. In this case, the investor with the contract after its expiration will be responsible for storing the product and will need to cover the costs of material handling, physical storage and insurance.
Speculators can use futures contracts to bet on the future price of some asset or security. Hedgers use futures to lock in prices today to reduce market uncertainty between now and the time the product is delivered or received. Arbitrageurs trade futures contracts within or across related markets, taking advantage of theoretical pricing that may exist over time.
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