Futures are complex and volatile, but also useful investments.
Futures belong to the group of financial products known as derivatives because their prices reflect, or are derived from, the value of the commodity underlying the futures contract. Commodities can be consumable, such as sugar and wheat, or financial, such as an index or a particular stock.
Futures developed from forward contracts, which were originally used by commodity producers — corn farmers, for example — to lock in the price they were to be paid for corn when it was harvested some months later. With the contract in hand, the farmer was protected if corn prices dropped.
Futures contracts formalized the forward-contract process, imposing standard contract terms for grade, or quality, quantity, and delivery month. With the imposition of standard terms, it became possible to trade futures contracts on an organized exchange, creating a futures marketplace.
Buying or selling a futures contract does not transfer ownership. Rather, the contract spells out the terms of the deal, including the rights and obligations of the buyer and seller, the underlying product — also called the underlying instrument or just the underlying — to be purchased or sold, the quantity, and the timing.
Leverage and Risk
Leverage, in financial terms, means using a small amount of money to control an investment of much greater value. Futures contracts are highly leveraged instruments. Under most circumstances, you can buy or sell a futures contract with a good faith deposit called an initial margin, which is a percentage of the underlying item’s value, often 10% but 20% for a security future.
For example, if you buy a gold contract worth $125,000 when the futures contract represents 100 ounces of gold and the gold futures price is $1,250 an ounce, the required good faith deposit might be $12,500. That gives you 10-to-1 leverage since you control the $125,000 investment with your $12,500 deposit.
As another example of how leverage affects the value of a futures contract, consider a situation in which the price of the commodity underlying a contract increased $30, $40, or $50 per unit within a short period. If the price went up $50 per unit and the contract covered 100 units, the value of the contract would jump $5,000. Of course, the opposite could also happen. If the price per contract unit dropped $50, the value of the contract would drop $5,000.
So while leverage means that the initial amount required to buy a futures contract, known as opening a futures position, is relatively small, changes in the market price of the contract are magnified in relation to your initial deposit.
Typically, futures contracts are traded only on the exchange that lists them rather than on multiple exchanges as securities are. The listing exchange develops a contract’s terms and conditions, provides speedy clearing and settlement of trades, and ensures that obligations to buy or sell are met.
Similar or even identical contracts may trade on more than one exchange, but normally one contract on a particular commodity dominates the competition in trading volume and liquidity. In other cases, an exchange may have the exclusive right to list contracts on a particular commodity.
Understanding Leverage. Are Futures Risky? by Inna Rosputnia
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