By Larry Wright
If you have been speculating the ins and outs of the crypto market, what is presently in action, exchange-traded funds, decentralized apps, and various other such elements, then you already know a bit about forward and futures contracts. The crypto space is rapidly evolving, and it is bringing forward many opportunities to the traders and investors of the present; it would be a fool’s play not to take advantage of what the crypto market is offering currently. About forward and futures contracts, you need to understand only one thing, and that is the fact that these are agreements that allow traders and investors to be able to speculate the future price of a dedicated asset.
It is simply like orchestrating a trade that will take place at a certain date in the future, and the trader in question who has invested their money on a certain asset would have to pay the price for that specific asset on a particular future date. The price is discussed and agreed upon when the contract is drafted between two parties. This allows both parties to form a proper bond that they can’t break out of. This way, a trader gets leverage on the commodity producer by giving them a subjective price for the asset that they will be acquiring or demanding from them at a later date.
At the heart of a futures contract, you can place anything; it can be a stock, forex entity, crypto, or even a commodity. Everything works great with a futures contract, and this is something that people are exploring just now and seeing the amazing benefits that it has to offer. The futures contracts are a more standardized form of contracts, and these are taken as legal agreements in which two or more parties interlock with each other on a business deal on the set terms, and they can’t break out of these terms until unless the contract is honored from both sides.
There can be a wide array of rules that can be set for futures contracts, such as the size of the contract, how much investment can be made, and interest rates that are agreed upon when drafting these contracts. There is a need for a third payment processor or an intermediary to ensure that these contracts would be executed based on the terms that are agreed by both parties. This sincerely reduces any and all counterparty risks that might be infiltrating the terms of the contract. With the introduction of cryptocurrencies and modern trading systems, futures contracts have gained a lot of popularity, and their use case has also improved; these are being treated as a potential opportunity that is available for all to take advantage of.
Top-Notch Features of Futures Contracts
As explained earlier, there is a wide array of functions that could be completed by these futures contracts, and to understand some of these, take a look below;
- Risk Management and Hedging
You can dive into futures contracts for the sake of eliminating a specific risk that you can foresee affecting a business deal or a crypto endeavor for you in the near future. Suppose someone has produced a certain commodity, and the market for that specific commodity is not at its full swing presently. So they can sell futures contracts of their products to make sure that they get a more favorable price in the future when these unfavorable events and market instability is done for.
And Investors within the forex market can sell the futures contracts for the particular fiat currency that they are presently holding and pull themselves out of the insane market fluctuations that they see at the moment, driving the price of the asset that they have invested in down. This way, they will get a more reasonable price for their specific entity in the future. So what futures contracts do is mitigate risks and work as a hedge during uncertain times and market cycles.
- Leverage
An investor can develop multiple leverage positions with the help of futures contracts. This is something that futures contracts allow them to do. Suppose you are an investor and you want to invest in a particular commodity whose price is just above the roof at the moment, so what do you do? You get in contact with the people who are producing that specific commodity at the moment, and you ask them to get into a futures contract with you.
You can set the terms of the contract in a way that benefits you in the future, such as lowering the price of the commodity for a later date, thus leveraging your position with the commodity producer. So when that particular time arrives, you would have to pay only the agreed-upon sum, but at the same time, if the market conditions continue to plummet and prices continue to spike, then the commodity producer would not be obliged to fulfill the terms of the agreement because the market didn’t calm down or rebooted but got worse and that is something that is out of their hands. Similarly, a trader could invest triple the amount of investment that they presently have in their trading account with the help of a futures contract, creating immense leverage.
- Futures Contracts Provide Short Exposure
Sometimes it is not certain or apparent to a trader or investor whether they should approach a certain commodity or a cryptocurrency. That is why they are always in a pickle deciding whether they should put their foot down and invest some of their money into that particular asset or not. There is the added risk of all their investment amounting to nothing and, at the same time, the confusion that would always remain; what if this was the next winning cryptocurrency and they just blew this amazing opportunity?
With the help of futures contracts, these traders and investors can take short exposure towards that specific asset. It means that you won’t be owning too much of it, but only a calculated amount, and you would always be covered by the metrics and rules of the futures contract, thus incurring less and less loss while at the same time giving availing the opportunity of checking out the asset in question.
- Access to Wide Variety of Asset Classes
With the help of futures contracts, traders and investors can get proposed exposure to assets that are typically more difficult to be traded. Such as, in the case of the oil market, it is a bit of a costly endeavor that pays handsomely but in the beginning requires a tedious amount of money for managing the delivery of the oil from one place to another, its containment, and other quality assurance procedures that are involved during this whole hiccup. With the help of futures contracts, traders and investors will be able to trade in oil without having to physically deal with the asset, and that is the most elementary aspect of futures contract that is providing the trader with a wider array of access to multiple assets.
- Discovery of Price Values
The most basic definition of any market is where supply and demand actually meet. There is a demand for something, and people take arms to make sure that the specific demand is met through the abundant supply of that commodity, and that is how a market works.
Futures markets are practically the go-to shop for both sellers and buyers that want to explore multiple asset classes and commodities. This leads to price discovery for various assets; with the help of futures contracts, you can explore the present price of oil in real-time, directing to the unraveling of the whole thing within the futures market rather than having to go to or visit a gas station to know the current price of oil or diesel at the moment.
Settlement Mechanisms of Futures Contracts
When a futures contract is drafted, an expiration date is also set to ensure that the contract is binding and will only last for a dedicated amount of time. The expiration date marks the last day for the contract when it actually holds any value; past this expiration date, the contract is of no value whatsoever. After the expiration date is reached for a certain contract, all kinds of trading activity are completely halted, and the contracts are given a reboot which means that the terms and conditions would be set from the beginning once again, and any and all alterations required would be made here.
To be able to get on with the settlement for a dedicated futures contract, there are practically 2 main mechanisms in action. Following is a brief description of what these mechanisms are all about and how you can undertake the editing of a dedicated futures contract and its settlement.
- Physical
During this type of settlement mechanism, the asset in question is exchanged between the parties involved who earlier agreed to conduct business at a predefined price and for a later date or at a specific future event. The selling party, therefore, is obliged to deliver the asset to the buying party before the expiration date is met. All of these situations and settlements take place physically, thus the name physical settlement.
- Cash Settlement
This type of settlement mechanism is approached when there is a practical limitation to the delivery of the asset, and it is more convenient to just pay the other party pertaining to the present value of the asset in question. Remember that any two parties involved in business with the help of the futures contract can’t back out of it and have to deliver the asset or commodity in question to the buying party for the sake of the payment to be released.
In the case of cash settlement, the asset in question is not being exchanged physically, but one party is going to pay the other one a dedicated amount which practically reflects the present value of the asset. Take the example of the oil futures contract, in this type of transition cash, is exchanged between two parties doing business on oil rather than the shipments or barrels of oil because it would be too tedious of a task to physically trade hundreds of barrels of oil barrels as it is practically easy to transfer the overall amount of money pertaining to those barrels in question.
Usually, cash settlements are much more convenient because there is no hard work involved in explicitly exchanging and shipping the products or assets in question, and these remain a more popular approach among investors rather than physical settlements.
If the trader gives in to temptation and to the circling bit of news that the asset is going to drown or increase in value, then it gives manipulators a fair edge to manipulate the market and, therefore, the price of the asset in question. A more sophisticated term for this type of manipulation of a dedicated market is known as ‘banging the close’; it refers to the abnormal patterns of trading that are going to stir rather tumultuous havoc among other futures contracts as they are approaching their expiration date.
Effective Exit Strategies for Futures Contracts
After you have secured yourself a position with one of these futures contracts, there are possibly three things that you can do;
- Offsetting
This means that you no longer require the services of a futures contract and have decided to close it for good, and to do so you have to create and perform an opposite transaction pertaining to the same overall value for the asset in question. It means that if you are a trader and you are short 10 futures contracts, then you can open a rather long position of the same standing which will allow you to neutralize the initial position that you had. This kind of strategy is used preemptively by traders around the world to analyze their profits and losses way before the expiration date for futures contracts reaches.
- Rollover
This is a phenomenon that pertains to a trader who has decided to get into a new futures contract position after they have canceled or offset a previous one. This new features contract that has been drafted will essentially last or extend all the way to the expiration date, suppose. You want to get out of a futures contract, then you can initially offset your position regarding that particular futures contract and then can extend it to whatever date or at a later future event. This allows you to cancel your initial position and then open a brand new which is of the same size as the new expiration date, which allows you to browse the market a bit more realistically.
- Settlement
Initially, a futures contract is designed in such a way that when the expiration date occurs, the prospects or the key points of the contract or owner and position is closed for good. No consensus is required from the trader or investor in question if the expiration date arrives before they have decided to either offset or roll over the position that they currently have with the smart contract. Nothing can be done with this specific point arrives, and the expiration date is set, which means that there is nothing the involved parties can do except to exchange their assets according to the initial draft which they drummed up when deciding to launch a smart contract between them.
Start the end of the day; futures contracts are extremely diverse and distinctive financial tools that can be used for a variety of use cases. They can be used in bilateral financial industries such as both in stocks and in crypto and, if need be, in the commodity market as well. That is why futures contracts are keenly observed and approached by traders and investors of variable backgrounds.
But in order to conduct business in future contracts or to bring them into your day-to-day financial operations, it is always a good thing to have a proper understanding of their mechanism and the markets that these correlate with. Because if you don’t then you are just going to mess the whole thing up, not knowing what to do and what steps to take; this information can play a key role in assessing your next steps.
While it might sound like a relief to have the price of an asset locked within the futures contracts but it is not going to help you at all if these contracts are being traded on margin. You must employ certain risk management strategies to remove any array of doubt or complication that you have left with a certain futures contract. Other than that, it is also important to run a deep technical analysis to get a proper insight into the current price action of the futures markets, or otherwise, this whole thing could be for nothing.