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Understanding the Futures Market

Understanding the Futures Market
May 25
17:16 2012

‘Futures’ are a type of financial transaction or contract where a party agrees to purchase or sell an asset at a predetermined future date and price. Futures trading began in the 1840s as a way for farmers to secure dealers that would commit to buying their produce. Farmers would meet with dealers at a central place to exchange a written contract to exchange cash for an immediate purchase of the product. Futures trading has changed with the introduction of speculators.

Today, these contracts are bought or sold on electronic futures exchanges and does not actually require the purchase of the product. Futures can be used as to invest, to hedge against risk, or to speculate. The underlying asset can be a stock, physical commodity, currencies, interest rates or an index. The contract has a delivery date at which time one party is expected to make a payment delivered by a specific date at which time the payment or release the settlement, which can either be cash or a physical good.

When someone buys a futures contract in the hopes that the price will increase, this position is called a “long.” When someone sells a futures contract in the hopes that the price will decrease, this position is called a “short.” The price of futures products can be influenced by overall market conditions, seasonal influences or unexpected events such as natural disasters. One of the most commonly traded futures contracts is that of crude oil.

In order to participate in the transaction each party involved in a futures contract must put up an initial amount of cash, this is called the margin. This is to ensure that both parties are able to fulfill their obligation and to cover the potential for losses on the part of the exchanges. The margin is typically about 5% to 15% of the underlying contracts value. The relatively low margins make these financial instruments more risky due to the ability to use a substantial amount of leverage.

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