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What is futures trading, and how does it work? We explore this topic here.
As the world’s financial markets have continued to evolve over time, traders have been able to access a wider range of asset classes and investment vehicles.
Some of these are more popular than others, of course. For example, a so-called “futures contract” offers a particularly appealing option to investors across multiple marketplaces.
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But what exactly is futures trading, and how does it work? We explore this in the article below.
What Is Futures Trading?
In simple terms, a futures contract is an agreement to buy or sell an asset at a predetermined price and time in the near term.
Such contracts are standardized agreements which are typically made on an exchange. Essentially, one party agrees to buy a given quantity of securities or a particular commodity, promising to take delivery on a future date.
For their part, the selling party agrees to provide the asset in question. Everyone from seasoned and traditional investors to speculators utilizes this investment vehicle.
How Does It Work?
Typically, futures trading is synonymous with popular commodities. For example, oil, orange juice, and even pork bellies are commodities that fall into this category.
However, the practice has evolved considerably in line with the emergence of virtual brokerage sites. This means you can now trade the futures of a wider and more diverse range of assets.
These assets include stocks, bonds, and shares of exchange traded funds (ETFs). They even include the market-leading cryptocurrency bitcoin.
Not only this, but futures options also expose investors to increased leverage across these asset classes and marketplaces. This enables traders to control disproportionately large positions with just small amounts of capital.
But How Exactly Do Futures Options Work?
Well, let’s say an airline company wants to lock in jet fuel prices. They might do this as a way of avoiding unexpected increases in the near term.
To achieve this, they secure a relevant futures contract agreeing to buy a fixed amount of jet fuel for delivery at a predetermined point in time. Simultaneously, a fuel distributor may sell a futures contract to guarantee access to a steady market. This allows the distributor to hedge against an unforeseen price decline in the process.
The two parties can then agree on the terms, stipulating the price, quantity for procurement, and the time frame for delivery and exchange.
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What Sort of Timeframes Govern Futures Contracts?
A standard-length futures contract is considered to be three months. This covers the typical life cycle for the investment vehicle.
A contract of this length is thought to optimize liquidity and opportunity while creating greater price efficiency. Moreover, it holds significant appeal for buyers and sellers alike.
While longer traders sometimes secure longer futures contracts, there’s generally little benefit to following such a course of action. The exceptions might be that the underlying asset is significantly underpriced or overpriced. Such a situation could change the perceptions of each participating party.
A trader might even roll over their position and remain in their chosen market after the original futures contract expires. This would seamlessly close the initial agreement and open a new one with revised timeframes.
Although this may require a trader to cover transaction costs, these are nominal in their nature and can be offset with the potential for increased or sustained gains.
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