Futures contracts are a popular financial instrument individuals, businesses and investors use to hedge against potential losses resulting from price fluctuations in various markets. Here, Leeloo Trading explores how futures are used for hedging against potential losses in various markets.
What is a futures contract?
A futures contract refers to an agreement between two parties to buy or sell a particular asset at a predetermined price on a set future date.
The use of futures contracts has recently become increasingly popular, and businesses are now using them to manage risk and ensure financial stability.
In this article, we will examine the use of futures contracts to hedge against potential losses in various markets.
Explore the assets that can be traded in the futures market.
What is Hedging?
Hedging is a financial strategy that involves taking a position in a market to offset the risk of an adverse price movement in another market.
The objective of hedging is to minimize potential losses by locking in a price that offers financial stability.
For example, suppose a business is importing goods from another country and expects to pay for them in the future. In that case, the company may use futures contracts to lock in a price for the goods, thus eliminating the risk of adverse price movements.
Using futures contracts to hedge
Futures contracts are a popular hedging tool because they offer a high degree of flexibility and are highly customizable.
Futures contracts are available for a wide range of underlying assets, including commodities, currencies, stocks and indices.
One of the significant advantages of using futures contracts to hedge is that they offer a high degree of liquidity.
Futures contracts are traded on exchanges and traders can buy or sell them anytime during the trading day.
This means traders can quickly exit a position if the market moves against them, thus minimizing potential losses.
Futures contracts also offer a high degree of leverage, meaning traders can control a large position with a relatively small amount of capital.
This makes futures contracts an attractive option for traders who want to take a position in a market but do not have the capital to do so outright.
Hedging with futures contracts
There are two primary ways to hedge with futures contracts, long and short selling:
What is long hedging?
Long hedging involves taking a long position in a futures contract to hedge against a potential hike in the price of the underlying asset.
For example, a business that is expecting to buy a commodity in the future may take a long position in a futures contract for the commodity to lock in a price.
If the price of the commodity increases in the future, the business can sell the futures contract at a profit, which will offset the increased cost of buying the commodity.
On the other hand, if the commodity's price decreases, the business will incur a loss on the futures contract, but will benefit from the lower cost of buying the commodity.
What is short hedging?
Short hedging involves taking a short position in a futures contract to hedge against a potential drop in the price of the asset.
For example, a business that is expecting to sell a commodity in the future may take a short position in a futures contract for the commodity to lock in a price.
Suppose the price of the commodity decreases in the future, in that case, the business can buy the futures contract at a profit, which will offset the lower selling price of the commodity.
However, if the price of the commodity increases, the business will incur a loss on the futures contract, but will benefit from the higher selling price of the commodity.
Futures contracts are a powerful hedging tool that can help businesses and investors manage risk and ensure financial stability.
By taking a position in a futures contract, traders can lock in a price for an underlying asset and minimize potential losses resulting from adverse price movements.
Whether you are a business owner looking to manage risk or an investor looking to make a profit, futures contracts offer a high degree of flexibility and liquidity, making them an attractive hedging option.
However, it is essential to understand the risks involved in trading futures contracts, develop a sound trading strategy, and choose one of the trusted trading apps that suit your individual needs and objectives.
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