A futures contract is a financial derivative that involves an agreement between two investors to buy or sell an asset in the future (referred to as the underlying asset). The basic terms of the agreement, including the price, are established at the time the contract is signed.
It is an investment vehicle. An investor can take two positions when buying a financial future. He is said to open a long position when he buys futures. On the other hand, he is said to open a short position when he sells futures. Futures are characterised in that both buyer and seller have obligations.
Obligations of a financial future
The obligations of each of the parties to a futures contract are as follows:
- Buyer: He has the obligation to buy the underlying asset by paying its price on the established date.
- Seller: He has the obligation to sell the underlying asset by receiving its price on the established date.
This obligation is only required at the time of expiration of the contract, but it is worth noting that it is not necessary to hold the contract until expiration. This is because a position can be closed by taking the opposite transaction, selling in the case of having a long position, or buying in the case of having a short position. As a result, the corresponding profits or losses are obtained.
The price of the futures contract will move in parallel with the current market value of the underlying asset. Therefore, a futures buyer will make a profit if the price of the underlying asset at that time is higher than the one agreed upon in the transaction.
In the case of a futures seller, he will make a profit if the price of the underlying asset is lower than the agreed price. Thus, both futures buyers and sellers will have their expectations of how these assets will behave in the future. It can be summarised as follows:
It is important to know that when you contract a future you do not have to pay the value of the underlying asset (as for example with stocks), but only provide collateral which ranges between 10% and 20% of the market price. This means that these types of assets have a great leverage, which has both advantages and disadvantages.
Finally, futures have been traded for a couple of decades, but their origins date back to 2,000 B.C. in ancient Egyptian times. Farmers, not knowing the quantity or quality of their crops in the future, would agreed with a buyer on a price for the entire crop regardless of the outcome. Later on, futures were also used during different periods, such as during the Tulip Mania.