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A futures contract is a type of financial instrument that obligates the buyer and seller to make a future transaction using a price that is set currently. If you purchase a futures contract, you are agreeing to buy something in the future for a price that is established now.
Most people who take part in the futures market do so because they want to hedge or lower their risk, or alternatively speculate or increase their risk. SmartMoney notes that market participants who use the financial instruments can hedge against significant price swings - whether these entail increases or declines - or alternatively speculate that prices will move in a certain direction.
In "A Guide to Understanding Opportunities and Risks in Futures Trading," The National Futures Association describes the purpose of the market for these financial instruments as "to provide an efficient and effective mechanism for the management of price risks." By purchasing and selling futures contracts that specify a price for the underlying asset being traded, people and businesses are able to ensure against price changes.
Types of Futures
The NFA indicates that futures contracts are based on a list of underlying assets that is always growing. For example, you have the ability to trade February gold futures on the Comex division of the New York Mercantile Exchange. Alternatively, you could purchase S&P 500 Index futures.
The NFA states that futures contracts can also be based on U.S. Treasury bonds, foreign currencies, stock indices, precious metals, traditional agricultural commodities and petroleum products.
A futures contract has two parties - the participant with the long position, who is agreeing to buy the underlying asset, and the participant with the short position, who is stating he will sell the underlying asset.
When the contract is made between the two parties, all pertinent variables need to be specified. The amount of the underlying asset that will be delivered, the specific price per unit, the date and how the transaction will be made all require clarification.
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