Regardless of how successful and appealing a trading instrument is as the primary asset, traders will want to diversify their portfolios, and that’s simply acceptable! Portfolio diversification is a key factor in increasing the stability and performance of trading. Therefore, we welcome you to learn more about a high-profit instrument that needs your attention while diversifying a portfolio. We’re talking about futures contracts, or futures. Diversification of an investment portfolio is the practice of investing funds in a variety of assets in order to reduce total risk.
The futures contract: an explanation
Futures are exchange contracts that represent an agreement to purchase or sell an item at a certain market price at a future date. Precious metals, oil, gas, securities, stock indices, commodities, currencies, and bonds can all be used as the underlying asset. The exchange operates as a middleman between suppliers and buyers.
Notably, futures contracts are not uncommon, having been practiced in agricultural trading since prehistory. In the past, the terms for buyers and suppliers of a product were agreed upon verbally between the European and American markets.
Imagine a farmer planting wheat in the spring. He now offers to sell 1 tons of wheat to a prospective buyer at the going rate of $100. The price may be greater (or less) than the going rate on the market, or it may be equal to it. The key is that it should be agreed upon by both the buyer and the seller. According to conventional thinking about the weather, the farmer predicts a warm summer that will result in a good harvest in the fall. If these theories are correct, there will be an excess of wheat on the market, which might cause prices to drop. A dedicated farmer, however, does not desire to sell his wheat for only $30 to $50 per tons.
For this reason, he has already decided to sell wheat to a number of prospective purchasers for the price of $100. In this instance, the futures contract protects the seller’s interests and sets the price of wheat that will only be delivered in the fall.
As a result, the futures contract allows purchasers to secure a favorable price while allowing sellers to schedule the delivery of their commodities.
Types of futures
Futures contracts are classified into two types:
- non-deliverable, or cash-settled.
The delivery of the underlying asset is implied by a deliverable futures contract. For instance, the parties agreed to provide wheat in six months at the existing price. In other words, the buyer is obligated to buy the asset on the futures expiration date, while the seller is required to sell the specified quantity of the asset.
No delivery is necessary when trading futures with a cash settlement. In this instance, the seller and buyer settle in cash the difference between the contract price of the non-deliverable futures and the actual price of the asset on the expiration date of the futures.
Instead of buying a real commodity, traders often try to make money by trying to predict futures contracts. The most widely used financial instruments among investors are typically currency futures, securities futures, and stock index futures.
The terms “the price of the futures contract” and “the price of the underlying asset” are frequently confused by new traders. Despite being related, these values are different from one another. Therefore, the futures price refers to the contract’s current price. The price of the underlying asset is frequently greater or lower than this value.
Trading futures contracts allows you to access a diverse set of trading instruments. Additionally, this is a fantastic strategy to diversify your portfolio with little danger of financial loss. The strong liquidity of the futures market is another benefit, which explains why many traders use this instrument globally.