The Act of Hedging in the Futures Market
The futures market can be a great way to hedge against a price rise or a price drop. It allows producers and consumers to take advantage of hedging to minimize the risk of losing money due to price fluctuation.
The act of hedging helps the way our economy functions by allowing producers and consumers to price in the price fluctuation. If there is a huge drop in price, producers will cut production and consumers will both cut down on spending until the price of the commodity changes. That’s why the futures market is important.
Example: If a farmer plants wheat in summer. The farmer runs the risk of losing money during harvest and sale when the price drops. The farmer can minimize this risk by offering futures contracts that guarantee a predetermined price when harvest time kicks in.
The futures contract
The futures contract is a contract between the two parties to exchange a commodity in the future at a predetermined price.
The contract is prior to the actual use of the commodity: wheat/barley/rice.
When the contract is sold, the buyer is purchasing the right to receive the commodity based on the agreed-upon price at a future date.
For example, the contract reads as follows: “The seller agrees to deliver 10,000 bushels of wheat at a price of $1.50 per bushel at the end of the month of September.” The buyer will pay the price of $1.50 per bushel for the commodity or the difference, if any, between the contract price and the actual price at that time.
Effect of a futures contract on the economy
Futures contracts help the economy because they allow people to lock in a price. The price includes a margin of safety. This is important because if the price of wheat goes up, the farmer is guaranteed to make the original contract price even though the wheat was sold at a lower price.
Futures contracts have the same effect on the economy as any other type of security. If futures contracts cannot be traded, the opposite effect will occur.
For example, if a farmer cannot sell contracts to cover the future price for wheat in exchange for a negotiated price, he or she must sell it at the price at which it was purchased.
Trading futures contracts
Trading futures contracts is easier to understand when the contracts are traded in a real environment. Retail traders and professional traders alike can benefit from futures trading if they know how to trade futures contracts.
If you’re an individual who sees potential for futures trading, it can be done in any environment. But there are some environments that are more conducive to futures trading than others. If you are interested in trading futures contracts, you may as well take a look at overseas futures trading too. A Plus Assets offer this type of trading (해외선물).
How to trade futures contracts
How to trade futures contracts can vary depending on the type of futures contract and the trading environment.
The most common type of futures contract is the option contract. An option contract works like this:
- An option is a right to purchase or sell a futures contract at a predetermined price. It can be exercised at any time before the expiration date.
- The differential between the price of the futures contract and the current price of the stock is the option premium. The premium is paid to the options broker.
- The option broker must be certain that the buyer will be able to pay back the premium.
- Option contracts are closed through the clearinghouse process or they can be traded on an exchange.
Options are traded electronically on an exchange where they are then converted into the underlying commodity. The underlying commodity is then traded on the exchange. The option contracts are then converted back into cash.
Examining the Role of Futures Contracts
Futures contracts are a cornerstone of the economy because they allow producers and consumers to act on the basis of future conditions to reduce or eliminate the risk of loss. The futures market is an important tool for hedging and can be used as a form of credit as well as a hedge.