What is a Futures Contract, and How is it Different from CFDs?

In a world where changing commodity prices can wreak havoc on smooth business operations, planning for the future becomes imperative. As organizations scramble to arm themselves against these volatile prices, a futures contract in the armory can help hedge against these risks. As the name suggests, futures contracts are an agreement between two parties for buying and selling an asset or security at an agreed price in the future.

Let's dive into understanding the basics of a futures contract and everything it entails.

What Is A Futures Contract?

To go by definition, futures contracts are legally binding agreements to buy or sell a specific commodity asset, securities, or both at a defined price at a predetermined future date. For facilitating trading on a futures exchange, futures contracts are standardized for quality and quantity.

When purchasing a futures contract, the buyer assumes the responsibility for purchasing the underlying asset at the contract's expiration, and the seller takes on the obligation of delivering it. They are most commonly associated with commodities trading. However, they also apply to other assets, including government bonds and indices.

How Does A Futures Contract Work?

Futures contracts function by following the spot price of an underlying market while accounting for variables, including volatility, the amount of time until delivery, interest rates, and the cost of carrying a position.

Common to most trading strategies, futures contracts are generally higher than the spot price as the aforementioned factors come into play. Here the market is said to be in contango. Conversely, if the futures contract settles on prices lower than the spot price, the market is said to be in backwardation. However, when the contract expires, the asset price equals the spot price.

Upon expiry, you can continue to hold the position and extend the contract or opt-in for a settlement. There are two types of settlements:

Physical Settlement: It involves the actual delivery of the asset, a common practice for companies relying on commodities. Fuel for an airline company, for example.

Cash Settlement: Common among speculators and hedgers who position themselves according to the rise and fall of prices, this settlement is carried out in cash.

Let's Take An Example

Consider a wheat farmer getting into a futures contract with a bread manufacturer. The farmer sells 15,000 bushels of wheat for $3 per bushel in the coming month. Here the farmer protects the price of his crops while the bread manufacturer gains control over his quarterly budget. So, if the price of wheat dropped to $2 per bushel, the farmer would still get $3 following their futures contract. However, if the prices rose to $4 per bushel, the farmer would face a loss unless they agreed to close their positions early.

Types Of Futures Contracts

Now that you understand how futures contracts work, you can invest in two types of futures contracts based on your trading strategy:

Commodity Futures: Futures contracts

Agricultural Futures like wheat, sugar, corn, etc.

Energy Futures like crude oil and natural gas.

Metal Futures like gold, steel, and copper.

Indices Futures: Indices futures contracts speculate on changes in index prices for different stock indices.

Futures Contract Vs. CFDs

Futures and Contracts for Difference (CFDs) are very similar because they are popular ways of trading indices, commodities, bonds and currencies. As two of the most popular financial tools, they are also easily accessible on online stock trading platforms.

However, before you start trading in them, it is also vital to understand the differences. Futures contracts and CFDs can be distinguished along the following lines:

Spread: The difference between an asset's buying and selling value is the spread. Trading in CFDs only requires one to pay the spread. In the case of futures, one has to pay the spread along with commissions charged by the broker.

Holding Period: CFDs incur an overnight financing cost, which makes them expensive with longer holding periods. This is not the same for futures contracts; hence, futures prices are relative to their expiry.

Expiry: CFDs do not expire because the trade is continuously rolled over, hence the overnight fees. You can keep your transaction open without having to close it and roll it into the next contract. Contrarily, when a futures contract is formed, the futures exchange sets an expiration date.

Futures contracts are, thus, one of the most common financial instruments, attracting investors from rural areas to the Wall Street markets. Now that you know them better, you can start planning a trading strategy with futures contracts in your portfolio.