Importance of Futures Contracts

There are many inherent advantages of trading futures over other investment alternatives such as savings accounts, stocks, bonds, options, real estate, and collectibles. Some of them are as follows:

1. Discovery of Prices: Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today’s and tomorrow’s estimated amount of supply and demand.

Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency.

Factors such as weather, war, debt default, refugee displacement, land reclamation, and deforestation can all have a major effect on supply and demand, hence upon the present and future prices of a commodity.

This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.

2. Reduction of Risk: Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is preset, therefore letting participants know how much they will need to buy or sell.

This helps to reduce the ultimate cost to the retail buyer because, with less risk, there is a lesser chance of manufacturers jacking up prices to make up for profit losses in the cash market.

3. High Leverage: The primary attraction, of course, is the potential for large profits in a short period of time. The reason that futures trading can be so profitable is the high leverage.

To ‘own’ a futures contract, an investor-only has to put up a small fraction of the value of the contract (usually around 10-20%) as ‘margin’.

In other words, the investor can trade a much larger amount of the security than if he bought it outright, so if he has predicted the market movement correctly, his profits will be multiplied (ten-fold on a 10% deposit).

This is an excellent return compared to buying and taking physical delivery in stocks.

4. Profit in both Bull and Bear Markets: In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long).

By choosing correctly, investors can make money whether prices go up or down. Therefore, trading in the futures markets offers the opportunity to profit from any potential economic scenario.

Regardless of whether we have inflation or deflation, boom or depression, hurricanes, droughts, famines, or freezes, there is always the potential for profit-making opportunities.

5. Lower Transaction Cost: Another advantage of futures trading is much lower relative commissions. The commission for trading a futures contract is one-tenth of a percent (0.10-0.20%).

Commissions on individual stocks are typically as much as one percent for both buying and selling.

6. High Liquidity: Most futures markets are very liquid, i.e., there are huge amounts of contracts traded every day.

This ensures that market orders can be placed very quickly as there are always buyers sellers for most contracts.

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