What is a Futures Contract?
Having highlighted the practical applications of futures, it is essential to understand what a futures contract really is. A futures contract is an agreement between two parties to do a deal, for instance, to exchange currencies, exchange stocks for money, etc. The asset in question is called “the underlying asset”). This exchange is obligatory. You cannot pull out of the deal in any other way than selling the futures contract – but will there be anyone willing to buy? that’s another question. The difference between a regular deal and a futures contract is that in the futures contract the parties agree on the price at which the currencies, stocks, commodities, etc.(the underlying asset) will be delivered at some specified future time. Market prices are subject to change in the time span between the agreement and the delivery. Therefore, futures give the opportunity to speculate or to hedge. For instance, if you believe that the price of gold will rocket, you can buy a futures contract to buy gold – the other side (who apparently does not believe that the price of gold will rise. They believe it will either stay the same or decline) agree to buy gold in the future for a price close to the current price (You believe that gold’s price will SURELY go above the offered price and if you buy futures for that price, you will make a bundle.) Please keep in mind that there are no SURE things in the market. Things are not BOUND to happen, they are just likely to happen, or not.).
If the futures contract goes your way and gold actually performs well and goes up, then you pay the agreed-upon price on the delivery date that was specified in the contract and in exchange you receive gold, which is worth more today than its price when you made the futures contract. This is speculation. You can speculate if you believe the price of gold will go up, and also if you believe the price will go down. In the former you are going “long”, and in the latter, you are going “short.” If you believe that gold will correct sharply, you can buy a futures contract to sell gold. The other side to the dealer agrees to sell gold in the future for a price close to the current price. If the price of gold does fall, then you get the gold on the delivery date for the agreed price, which is higher than the actual price at the time of the delivery date (because during the duration of the contract the price went down, which is what you believed will happen, which is why you made the deal in the first place.) The other party cannot deny you the right to get the gold at the agreed-upon price, even though they are losing money. The trade is obligatory for both parties.
Futures and Long-term Investments
We don’t view futures nor forwards as a good way to invest one’s long-term capital unless one dedicates a substantial amount of money for meeting the margin requirements in case of temporary adverse price moves. There are three main reasons for that:
Leverage and deposit requirements. The risk of being thrown out of the market because price declined very sharply and you need to increase your deposit (for which you don’t have cash at that moment) is quite high.
Risk of changing rules for the futures market. Regulatory agencies can impose virtually any requirement for holders of long futures contracts. For instance, you could suddenly face an increase in the required deposit levels that exceeds the actual value of the metal that would likely force you to get out of the market – things like that have already happened. Counterparty risk. This type of risk is minimized on the futures market because of the marking-to-market mechanism, however, it still exists. In case of a financial meltdown of sorts, we would likely see much higher gold and silver prices. However, if the futures exchange that you’re currently dealing with collapsed as well, then you might have trouble realizing your profits from your precious metals investments.