What is a Futures Contract?
A future is a derivative which can be traded on. It is a contract that means the buyer (seller) is obligated to buy (sell) an asset at a pre-determined date at a pre-determined price. Futures can be settled either in cash or in actual delivery of the asset.
A future is an example of a leveraged instrument. For example, if one was to buy a future for 1000 barrels of oil, they would not need to pay the full price of 1000 barrels, but it would be giving the holder exposure to that much oil.
This is an example of the performance of futures:
- Investor A sells Investor B a futures contract for 100 shares of Apple at $400 per share, and the cost of the contract is $20.
- At expiration date, Investor A is obliged to sell Investor B (who is also obliged to buy) 100 shares of Apple for $400 for a total of $40,000.
- If the market value of Apple shares is under $400, say $380, then Investor B has to buy the shares at a cost of $40,000 and will have made a loss of $2,020 ($38,000 - $20 - $40,000).
- If the market value of Apple shares is above $400, say $450, then Investor B will buy from Investor A at a cost of $40,000, sell them in the market at $450 and will have made a profit of $4,980 ($45,000 - $40,000 - $20).