A futures contract is a financial contract to buy or sell an underlying instrument at a fixed date in the future, at a specific price. Trading Futures is the buying and selling of futures contracts. Futures contracts can be issued on a variety of financial instruments such as commodities, equities, currencies etc.
In comparison to trading financial instruments directly there are a couple of advantages of trading futures contracts instead.
(1) Leverage: You are able to control larger quantities of the financial instrument with smaller amounts of money. An investor can control the underlying instrument by paying a fraction of the value of the contract (also called margin). In this manner the investor has access to 100 ounces of gold for a couple hundred dollars.
(2) Minimal transaction costs: Due to the liquidity of the futures market, the transaction costs are very competitive hence usually minimal.
(3) 'Shorting' and Tax advantages: Another advantage is that investors can "short" the futures contract or be the seller. This technique can be used to make money if the belief is that the price of the instrument is going down. In addition, there could be tax advantages in comparison with normal investing depending on the taxation laws in place.
Some disadvantages
Leverage is a double-edged sword. In the case where an investor purchases a futures contract by making a payment equivalent to margin and the price of the underlying instrument goes down, then the buyer could lose more than the initial stake in the transaction. That is why its very important to understand why trading futures for this reason is considered risky.
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