Key Definitions & Terminology

As you learned in the previous section, investing in futures refers to participating in the futures market. In short, the futures market involves buying or selling standardized contracts to buy or sell an underlying asset at a predetermined price on a specified future date. As with other investment classes, there’s some jargon to be aware of before becoming involved.

Important Concepts:

  • Futures Contract: A futures contract is an agreement between two parties to buy or sell an asset (such as commodities, currencies, stocks, or bonds) at a predetermined price and date in the future.
  • Underlying Asset: The underlying asset is the commodity, currency, or financial instrument that is being traded through the futures contract. Common underlying assets include agricultural products (e.g., wheat, corn, soybeans), energy products (e.g., crude oil, natural gas), precious metals (e.g., gold, silver), and financial instruments (e.g., stock indices, interest rates).
  • Long and Short Positions: Investors can take either a long position (buying a futures contract) or a short position (selling a futures contract). A long position is taken with the expectation that the price of the underlying asset will rise, while a short position is taken with the expectation that the price will fall.
  • Leverage: Futures contracts are traded on margin, meaning that investors only need to deposit a small percentage of the contract’s total value (called the initial margin) to control the full value of the contract. This leverage can magnify both potential profits and losses.
  • Speculation: Traders speculate on the future price movements of the underlying asset to make profits.
  • Hedging: Producers and consumers of the underlying asset can use futures contracts to hedge against adverse price movements, locking in a future price for their products or raw materials.
  • Expiration and Settlement: Futures contracts have expiration dates, and as the expiration date approaches, traders can either close out their positions by taking an offsetting trade or allow the contract to expire and settle by physically delivering or accepting delivery of the underlying asset.

Investing in futures involves substantial risks due to the leverage involved and the potential for significant price fluctuations. It is crucial for investors to understand the mechanics of futures trading, manage risk effectively, and have sufficient knowledge and resources to participate in this market.

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