What are Futures?

Summary

This video explains the concept of futures contracts, a type of investment where assets are bought or sold at predetermined prices for delivery at a future date. The video uses relatable examples, such as a baker securing a price for flour, to demonstrate how futures work, including both hedging and speculation. It discusses how these contracts allow investors to gain exposure to commodities like gold, oil, and even stocks, while managing risks using leverage. The video also touches on the complexity of futures markets and their significance for investors, providing insights into future price patterns and their applications.

Takeaways

• 😀 Futures contracts allow for the buying and selling of assets at a predetermined price in the future, which can help manage business risks.
• 😀 Futures were originally created to help producers hedge costs, but now they are widely used by speculators in various markets, including commodities and financial assets.
• 😀 The difference between futures and forwards is that futures are standardized contracts traded on exchanges, while forwards are customizable and negotiated directly between parties.
• 😀 Futures contracts can be used for various commodities such as oil, gold, and agricultural products, as well as financial assets like stocks and bonds.
• 😀 A futures contract obligates the buyer to purchase and the seller to deliver the asset at the future date, no matter how profitable or unprofitable the market conditions are.
• 😀 Leverage plays a key role in futures trading, meaning that investors can control large positions with only a small deposit, amplifying both gains and losses.
• 😀 In futures contracts, the price can be settled in cash rather than by physical delivery of the asset, which makes it easier for investors to speculate without needing to handle the commodity directly.
• 😀 Futures contracts come with risks, especially due to leverage, which can lead to significant losses if the market moves unfavorably.
• 😀 Speculators can take long positions (buy) if they expect prices to rise or short positions (sell) if they expect prices to fall, profiting from the price movements of the underlying asset.
• 😀 The 'future curve' is a graphical representation of future prices for different expiration dates, which can provide insights into the market's expectations for price trends over time.

Q & A

What is a futures contract?

A futures contract is a derivative agreement where two parties agree to buy or sell an asset at a predetermined price at a specified future date. The agreement obligates the parties to complete the transaction, no matter how profitable or unprofitable it may turn out to be.

How did futures contracts originally come about?

Futures contracts were originally created for producers to manage their business costs, such as farmers locking in the price of crops or materials. Over time, they evolved into a financial tool used by speculators and investors.

Why would a baker use a futures contract?

A baker would use a futures contract to lock in the price of flour for a future date, helping to ensure stable costs and protect against price increases, which could otherwise negatively affect their profit margins.

What does taking a long position in a futures contract mean?

Taking a long position means agreeing to buy the asset at the future price. In the case of gold, for example, the investor buys the commodity at a set price in the future, hoping that the price will rise before the contract expires.

How do speculators use futures contracts to gain exposure to an asset like gold?

Speculators use futures contracts to invest in assets like gold without physically buying the metal. They enter into a contract to buy gold at a predetermined price, hoping that the market price will rise, allowing them to sell the gold at a profit.

What happens if the price of gold goes up after entering a long futures position?

If the price of gold increases above the predetermined future price, the investor profits by buying gold at the lower price specified in the contract and selling it at the higher current market price.

What is the concept of shorting in futures contracts?

Shorting a futures contract involves agreeing to sell an asset at a future date, typically because the investor expects the price of the asset to fall. If the price does fall, the investor can buy the asset at the lower price and sell it at the higher agreed price for a profit.

What is a future curve, and how is it used by investors?

A future curve is a graph that shows the forward prices of an asset for different expiration dates. Investors use future curves to understand market expectations and price patterns, and to anticipate price movements based on factors such as seasonal demand, like with natural gas.

What is the risk involved in futures contracts?

The primary risk in futures contracts is the use of leverage, which means that investors can lose more money than they initially invested. For example, an investor could lose a significant amount if the price of the asset moves unfavorably.

How is leverage used in futures trading?

Leverage allows speculators to control a large contract value with a small margin deposit, such as 5% of the total contract value. While it magnifies potential profits, it also increases the risk of substantial losses if the market moves against the investor.