In trading, a futures contract is a legal agreement which obliges an investor to buy or sell an underlying asset at a predetermined time for a predetermined price.
A futures contract provides a seller or a buyer with the security of knowing that they will be able to buy or sell assets at an agreeable price regardless of market supply and demand. As such, futures contracts are similar to forward contracts. However, futures are traded on regulated exchanges, whereas forwards are not. Both of these instruments are used for forward transactions.
Futures are commonly used to protect commodities traders from sudden price hikes or decreases. For example, agricultural futures provide farmers with a guarantee that they will be able to sell their produce before they invest in growing it. Mining futures provide mining companies with the security of knowing that they will sell the commodities they mine before they invest in mining them.
Manufacturers use futures to secure the commodities which they need to manufacture their products at a reasonable price even if shortages or strong market demand drive prices up in the future.
Futures are a popular speculative instrument. If the price of the underlying asset rises above the price guaranteed by the futures contract, the assets can be purchased at the (lower) guaranteed price and then resold at the (higher) market price – earning the buyer a profit.
Likewise, if the price of the assets falls below the price guaranteed by the futures contract, the seller of the underlying assets can sell their assets at a guaranteed price which is higher than the market price – earning the seller a profit.
Trading of futures takes place on regulated, public futures exchanges. Some stock exchanges also have futures trading divisions.
In practice, investors rarely claim or deliver the physical commodities which they buy and sell. Instead, futures trades are generally settled in cash, with only the futures contracts themselves changing hands.
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