Skillsfirst Level 3 Certificate in Introduction to Financial Trading (RQF) - UNIT 1: Principles of financial trading
Skillsfirst Level 3 Certificate in Introduction to Financial Trading (RQF) - UNIT 2: Principles of Financial Planning and Cash Flow in Financial Trading
Skillsfirst Level 3 Certificate in Introduction to Financial Trading (RQF) - UNIT 3: Understanding financial trading techniques

WHAT IS A FUTURES MARKET?

Futures markets provide a way for people to manage price risks – enabling them to avoid “market volatility”. Buyers can obtain protection against rising prices and sellers can obtain protection against declining prices through futures contracts.

These contracts can be described as a legally binding agreement to buy or sell an investment, financial product or goods at a fixed quality, quantity and price on a specified date in the future. Put simply one could say a futures contract binds two sides to a later transaction. Futures markets became useful due to the outright risk and volatility of cash markets, for instance an exporter shipping goods abroad could shield itself against say currency fluctuation in the coming months by securing a futures contract at a known quantity and price right now. This means they can predict revenue without worrying about any interference from the underlying cash market.

The price of a futures contract is based on its underlying product along with many other factors that people believe will affect that particular product over the coming months. Although all futures contracts have specific contract months for delivery, contracts can also be sold before they expire. If one did fail to act on an open position before expiration (maturity) of a contract you could find yourself taking delivery of the relevant product. It has been known for forgetful traders to receive phone calls asking where they would like their tonnes of sugar delivered. However, this situation is normally avoided by taking an offsetting position before the expiration date.

Not everyone in a Futures market wishes to take physical delivery of a contract and this has given rise to speculators. Speculators trade purely for money profits by correctly forecasting market movements. They assume their own risk and provide the liquidity to the market which in turn has provided traders with greater opportunities to make money.

Hedgers use futures to protect a sale or purchase price in the underlying market, by either selling (go short) to lock in a price and obtain protection from declining prices or buy (go long) to lock in a price to obtain protection from rising prices, with the ultimate aim of reducing price risk. Hedgers are not normally interested in where the market goes as long as they are correctly hedged and will therefore avoid risk. Hedgers tend to be big institutional firms or producers known in the market as paper.

Here is an example of a futures contract and hedging. In the spring, Farmer Jones planted 100 acres of soybeans and he anticipates that in September he will harvest 5,000 bushels. He is concerned about what the prices of soybeans will be in September, if the price falls he will lose money. To avoid this risk, Farmer Jones has his futures broker sell a contract for 5,000 bushels of soybeans for September at the current price. In this way the farmer locks in his September selling price. If the price is higher in September, the farmer will not make as much profit, but if the price has fallen, he will come out ahead.

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