A futures contract is a standardized, legal agreement to buy or sell an asset at a predetermined price at a specified time in the future. At this specified date, the buyer must purchase the asset and the seller must sell the underlying asset at the agreed-upon price, regardless of the current market price at the expiration date of the contract. Underlying assets for futures contracts can be commodities–such as wheat, crude oil, natural gas, and corn–or other financial instruments. Futures contracts–also just called futures–are sometimes used by corporations and investors as a hedging strategy. Hedging refers to a range of investment strategies that are meant to decrease the risk experienced by investors and corporations.
Some corporations that are producers or consumers of commodities use futures contracts to reduce the risk that an unfavorable price movement in the underlying asset–typically a commodity–will result in the corporation having to face unexpected expenses or losses in the future.
When an investor uses futures contracts as part of their hedging strategy, their goal is to reduce the likelihood that they will experience a loss due to an unfavorable change in the market value of the underlying asset, usually a security or another financial instrument. If the security or the financial instrument typically experiences a lot of volatility, an investor may be more likely to purchase a futures contract.
Key Takeaways
- A futures contract is a standardized, legal agreement to buy or sell an asset at a predetermined price at a specified time in the future.
- Futures contracts allow corporations–especially corporations that are producers and/or consumers of commodities–and investors to hedge against unfavorable price movements of the underlying assets.
- When corporations invest in the futures market, it is usually because they are attempting to lock in a more favorable price in advance of a transaction they are required to make in the future.
- The main advantage for investors looking to participate in the futures market is that it can remove the uncertainty about the future price of a security or a financial instrument.
Using Futures Contracts to Hedge
When corporations invest in the futures market, it is usually because they are attempting to lock in a more favorable price in advance of a transaction. If a corporation knows that it has to purchase a specific item in the future, it may decide to take a long position in a futures contract. A long position is the buying of a stock, commodity, or currency with the expectation that it will rise in value in the future.
For example, suppose that Company X knows that in six months it has to purchase 20,000 ounces of silver in order to fulfill an order. Assume the current market price for silver is $12 per ounce and the price of a six-month futures contract is $11 per ounce. By purchasing the futures contract, Company X can guarantee a price of $11 per ounce. This reduces the company’s risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11 per ounce in six months at the contract’s expiration date.
If Company X had not purchased the six-months futures contract–and the price of silver ended up increasing from $12 per ounce to $14 per ounce after one month–the company would be forced to purchase the 20,000 ounces of silver at the price of $14 per ounce. This would result in a greater expense for the company (compared to the $11 per ounce price it could have guaranteed by purchasing a futures contract for silver).
On the other hand, if a company knows that it will be selling a specific item in the future, it may decide to take a short position in a futures contract. Shorting is the buying of a stock, commodity, or currency with the expectation that it will decline in value in the future.
For example, Company X may agree to a legal contract that obligates them to sell 20,000 ounces of silver at a date that is six months in the future if the current market price for silver is $12 per ounce and the futures price is $11 per ounce. When Company X closes out its futures position in six months, they will be able to sell its 20,000 worth of silver at $11 per ounce.
If Company X had not made the decision to take this position in a futures contract, and the market price of silver had unexpectedly dipped to $10, it would have been forced to sell every ounce of its silver at $10 per ounce (compared to selling every ounce of silver at $11 per ounce). In this situation, the company has decreased its risk that it will experience financial damage as a result of a steep decline in the market price for silver in the future. Company X has guaranteed that it will receive $11 for every ounce of silver that it sells.
The main advantage for investors looking to participate in a futures contract is that it removes the uncertainty about the future price of a commodity, security, or a financial instrument. By locking in a price for which you are guaranteed to be able to buy or sell a particular asset, companies are able to eliminate the risk of any unexpected expenses or losses.
How Are Futures Used To Hedge A Position?
Futures Contracts vs. Options
Like futures contracts, option contracts are also derivative financial instruments. With option contracts–also just called options–the buyer has the opportunity to buy or sell (depending on the type of contract they hold) the underlying asset. Options are different than futures because the holder of an option is not required to buy or sell the asset if they choose not to, whereas the holder of a futures contract is obligated to either buy or sell the underlying asset if it is held to settlement. As an investor, if you purchase a futures contract, you are entering into a contractual agreement to purchase the underlying security. Alternatively, if you sell a futures contract, you are effectively entering into an agreement to sell the underlying asset to another party.