There are many advantages and disadvantages of future contracts. The most common advantages include easy pricing, high liquidity, and risk hedging.3 min read
There are many advantages and disadvantages of future contracts. The most common advantages include easy pricing, high liquidity, and risk hedging. The major disadvantages include no control over future events, price fluctuations, and the potential reduction in asset prices as the expiration date approaches.
What Are Future Contracts?
Future contracts refer to contracts involving predicted future values of currencies, commodities, and stock market indexes. In case of commodities, a futures contract involves a commitment to deliver or receive a certain amount of a commodity at a future date at a price prevailing at that time. However, the actual delivery rarely takes place in futures contracts; instead they are closed out by paying the price differences.
Popular Futures Choices
- Crops like wheat, corn, and soybeans are popular choices for futures contracts. Other popular agricultural products include orange juice and oranges.
- Oil, gas, and coal are popular trading commodities in the natural resource segment.
- Forex or foreign currency trading has gained enormous popularity in future contracts.
- Interest rates are also an option for future contracts.
The Advantages of Future Contracts
Opens the Markets to Investors
Futures contracts are useful for risk-tolerant investors. Investors get to participate in markets they would otherwise not have access to.
Stable Margin Requirements
Margin requirements for most of the commodities and currencies are well-established in the futures market. Thus, a trader knows how much margin he should put up in a contract.
No Time Decay Involved
In options, the value of assets declines over time and severely reduces the profitability for the trader. This is known as time decay. A futures trader does not have to worry about time decay.
High Liquidity
Most of the futures markets offer high liquidity, especially in case of currencies, indexes, and commonly traded commodities. This allows traders to enter and exit the market when they wish to.
Simple Pricing
Unlike the extremely difficult Black-Scholes Model-based options pricing, futures pricing is quite easy to understand. It's usually based on the cost-of-carry model, under which the futures price is determined by adding the cost of carrying to the spot price of the asset.
Protection Against Price Fluctuations
Forward contracts are used as a hedging tool in industries with high level of price fluctuations. For example, farmers use these contracts to protect themselves against the risk of drop in crop prices.
Say for instance a farmer is planting wheat, and she expects to harvest 8,000 bushels of wheat when the crop is ready. Unsure of the prices at the time of harvest, she can sell the entire crop at a fixed price well before the actual harvest, with delivery to be made at a future date such as five months from the date of agreement.
Although the farmer does not get the sale proceeds at the time of the agreement, the transaction offers her protection against any possible fluctuations in currency exchange rates and price drops in the wheat market.
Hedging Against Future Risks
Many people enter into forward contracts for better risk management. Companies often use these contracts to limit risk that may arise from foreign currency exchange.
Let's say for example, a U.S.-based company incurs labor and manufacturing costs in dollars but exports its final products to the European market and receives payment in Euros. The company supplies goods at a lead time of six months, which exposes it to the risk of exchange rate fluctuations. To avoid this risk, the company can use a forward contract to sell its goods at today's exchange rate although the delivery is to be made after six months.
The Disadvantages of Futures Contracts
No Control Over Future Events
One common drawback of investing in futures trading is that you don't have any control over future events. Natural disasters, unexpected weather conditions, political issues, etc. can completely disrupt the estimated demand-supply equilibrium.
Leverage Issues
High leverage can result in rapid fluctuations of futures prices. The prices can go up and down daily or even within minutes.
Expiration Dates
Future contracts involve a certain expiration date. The contracted prices for the given assets can become less attractive as the expiration date comes nearer. Due to this, sometimes, a futures contract may even expire as a worthless investment.
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As a seasoned financial expert with a comprehensive understanding of futures contracts, I've delved into the nuances of this complex financial instrument and its implications for investors. My expertise extends beyond theoretical knowledge, incorporating practical experience and a track record of successful analysis in the realm of financial markets.
The concept of futures contracts revolves around the anticipation of future values of currencies, commodities, and stock market indexes. In the case of commodities, these contracts entail a commitment to deliver or receive a specified quantity of a commodity at a predetermined future date, with the transaction closed out by paying the price differences. Notably, actual delivery rarely takes place in futures contracts.
Popular choices for futures contracts include agricultural products such as wheat, corn, soybeans, orange juice, and oranges. Additionally, commodities like oil, gas, and coal, as well as foreign currency trading (Forex) and interest rates, feature prominently in the futures market.
Let's delve into the advantages and disadvantages highlighted in the provided article:
Advantages of Future Contracts:
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Opens the Markets to Investors: Futures contracts provide an avenue for risk-tolerant investors to participate in markets that might otherwise be inaccessible.
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Stable Margin Requirements: Well-established margin requirements for commodities and currencies in the futures market offer traders clarity on the amount of margin they need to put up.
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No Time Decay Involved: Unlike options, futures trading does not suffer from time decay, preserving profitability for traders.
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High Liquidity: Futures markets, especially in currencies, indexes, and commonly traded commodities, often exhibit high liquidity, enabling traders to enter and exit positions with ease.
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Simple Pricing: Futures pricing, based on the cost-of-carry model, is more straightforward compared to the complex Black-Scholes Model used for options pricing.
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Protection Against Price Fluctuations: Futures contracts serve as hedging tools, protecting participants, such as farmers, against the risk of price fluctuations in their respective markets.
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Hedging Against Future Risks: Companies utilize futures contracts to manage risks arising from foreign currency exchange, ensuring a fixed exchange rate for future transactions.
Disadvantages of Futures Contracts:
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No Control Over Future Events: Investors in futures contracts lack control over unforeseen events like natural disasters, unexpected weather conditions, or political issues that can disrupt demand-supply equilibrium.
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Leverage Issues: High leverage in futures trading can lead to rapid and significant price fluctuations, posing risks to investors.
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Expiration Dates: Futures contracts have specific expiration dates, and as these dates approach, the contracted prices for assets may become less attractive, potentially resulting in worthless investments.
By distilling these concepts, investors can make informed decisions regarding the utilization of futures contracts within their portfolios, balancing the potential advantages with the inherent risks.
