How Do Oil Futures Contracts Work – A futures contract is a legal agreement to buy or sell a specific commodity, asset or security at a predetermined price at a specific time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on futures exchanges.
The buyer of a futures contract assumes the obligation to purchase and receive the underlying asset when the futures contract expires. The seller of the futures contract undertakes to provide and deliver the underlying asset on the expiry date.
How Do Oil Futures Contracts Work
Futures are financial derivative contracts that oblige parties to transact an asset at a predetermined date and price. Here, the buyer has to buy or the seller has to sell the underlying asset at a fixed price, regardless of the current market price on the expiry date.
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Underlying assets include physical goods or other financial instruments. Futures contracts specify the amount of the underlying asset and are standardized to facilitate trading on the futures exchange. Futures can be used for hedging or speculative trading.
“Futures Contract” and “Futures” refer to the same thing. For example, you may hear someone say they are buying oil futures, which means the same thing as an oil futures contract. When someone says “futures contract,” they are usually referring to a specific type of future, such as oil, gold, bonds, or the S&P 500 index future. Futures contracts are also one of the most direct ways to invest in oil. . The term “futures” is more general, and is often used to refer to the entire market, as in, “They are futures traders.”
Futures contracts are standardized, unlike forward contracts. A forward is a similar type of contract that currently locks in a future price, but forwards are traded over the counter (OTC) and have normal agreed terms between counterparties. On the other hand, futures contracts will have the same terms regardless of the counterparty.
Hedging an underlying asset guarantees the price at which the producer or buyer of the commodity is sold or bought. They use futures contracts to ensure they have a buyer and a satisfactory price, protecting against any changes in the market.
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An oil producer needs to sell his oil. They can use futures contracts to lock in the price they sell, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company needs oil to make gadgets. They like to plan ahead and always get oil every month, they can also use futures contracts. This way they know in advance the price they will pay for oil (future contract price) and they know they will receive the oil when the contract expires.
Since many commodity prices tend to move in predictable patterns, it is possible to make a profit by trading futures even without a direct interest in the underlying commodity. Traders and fund managers use futures to bet on the price of an underlying asset.
For example, a trader may buy grain futures if he expects the price of grain to rise before the delivery date. Any unexpected changes in weather or growing conditions could cause prices to rise or fall in the future.
Futures contracts can be used to set prices on any type of commodity or asset, as long as there is a large enough market for it. Some of the most common types of futures traded are mentioned below:
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A futures contract is similar to a forward contract, where a buyer and seller agree to set a price and quantity of a product for delivery at a later date. Both types of contracts can be used for speculation, as well as hedging.
However, there are also important differences. While a futures contract is a standard contract that can be traded on an exchange, a forward contract is simply a private contract between a buyer and a seller. Although forward trading is possible in OTC markets, they are less regulated and less accessible to retail investors. This also means that there are more opportunities to adjust the contract in advance according to the needs of the buyer and the seller.
Imagine that an oil producer plans to produce a million barrels of oil over the next year. It will be ready for delivery in 12 months. Assume the current price is $75 per barrel. Producers can produce oil and sell it at the current market price for a year from today.
Given the volatility of oil prices, the market price at that time could be very different from the current price. If an oil producer thinks oil will be higher in a year, they may choose not to lock in the price now. But, if they think $75 is a good price, they can lock in a guaranteed sale price by entering into a futures contract.
What Are Futures And How Do They Work?
A mathematical model is used to determine the futures price, which takes into account the current spot price, risk-free rate of return, time to maturity, storage cost, dividend, dividend yield, and facility yield. Assume that one-year oil futures contracts are worth $78 a barrel. By entering into this contract, the producer is required to deliver one million barrels of oil per year and is guaranteed to receive $78 million. A price of $78 per barrel is secured which is the spot market prices at the time.
Contracts are standardized. For example, there is an oil contract on the Chicago Mercantile Exchange (CME) for 1,000 barrels of oil. So, if someone wants to lock in the price (sell or buy) of 100,000 barrels of oil, they have to buy/sell 100 contracts. They would have to buy/sell 1,000 contracts to lock in the price of a million barrels of oil.
Futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market prices, including the prevention of abusive trading practices, fraud, and the regulation of brokerage firms involved in futures trading.
Retail traders and portfolio managers are not willing to provide or receive the underlying asset. A retailer doesn’t need much to acquire 1,000 barrels of oil, but they may be willing to take a profit on oil price movements.
Futures Vs. Options: What’s The Difference?
Futures contracts can be traded for profit only, as long as the trade is closed before expiration. Many futures contracts expire on the third Friday of the month, but contracts vary so check the contract specifications of any and all contracts before trading them.
For example, it’s January, and April contracts are trading at $55. If a trader believes the price of oil will rise before the contract expires in April, they can buy the contract for $55. This gives them control of 1,000 barrels of oil. However, they do not need to pay $55,000 ($55 x 1,000 barrels) for this privilege. Instead, the broker only requires an initial margin payment, usually a few thousand dollars for each contract.
As the price of the futures contract moves, the profit or loss of the position in the account fluctuates. If the loss becomes too big, the broker will ask the trader to deposit more money to cover the loss. This is called the maintenance margin.
The final profit or loss of the business is realized when the business is closed. In this case, if the buyer sells the contract for $60, he earns $5,000 [($60-$55) x 1, 000). Otherwise, if the price drops to $50 and they close the position there, they will lose $5,000.
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A futures contract results from the fact that the buyer and seller of the contract agree on today’s price for the future delivery of an asset or security.
These two types of derivative contracts operate very similarly, but the main difference is that the futures are exchange traded and have standard contract specifications. These exchanges are highly regulated and provide transparent contracts and pricing data. In contrast, forwards trade over the counter (OTC) with contract terms and specifications customized by the two parties involved.
Unless the position of the contract is closed before it expires, the short is obliged to submit to the long, who is obliged to take it. Depending on the contract, exchange rates may be specified in cash. Often, the trader will pay or receive a cash settlement based on whether the underlying asset has increased or decreased during the investment holding period. In some cases, however, futures contracts require physical delivery. In this situation, the investor who holds the contract after it expires would be responsible for storing the goods and would need to cover the costs of material handling, physical storage and insurance.
Speculators can use futures contracts to bet on the future price of an asset or security. Hedging uses futures to reduce current market uncertainty and lock in a price between the best delivery or acceptance times. Arbitrageurs trade futures contracts on or in related markets, taking advantage of theoretical mispricing that may exist temporarily.
What Are Perpetual Contracts?
Depends on your broker and your account status
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