What are futures?
Futures are a financial derivative in which one party agrees with another party to buy or sell an asset at a predetermined price at some point in the future. Both physical commodities and financial instruments like stocks and bonds are traded using futures contracts. As a common derivative product, futures contracts themselves are traded on public exchanges in speculative deals.
Futures contracts are used to hedge risk and to speculate in the market. The buyer of a futures contract is referred to as holding a long position, while the seller is referred to has holding a short position. Futures are traded on public exchanges, and are standardized derivative contracts. A forward is a related, but separate concept; forward contracts are non-standardized futures.
Futures were originally developed to trade commodities such as agricultural products and minerals, and were used to minimize risks for producers from fluctuating market prices for their goods. By having an agreed-upon price for future delivery, producers were able to more effectively make long-term business plans. Speculators would enter futures contracts in the hope that the price they agreed to pay upon delivery was lower than the market price at that time, giving them a profit in exchange for agreeing to take on risk. From this basic premise, futures have grown to facilitate the exchange of almost every variety of financial product.
The contracts are settled in one of two ways: physical delivery, where one party delivering the underlying assets to the other party, or by cash settlement. Futures traders looking to hedge are minimizing potential losses from unfavorable changes in market prices. Futures are useful to this end, as it’s possible to fix a sale price on a commodity to maintain a specific financial outcome.
Speculating involves analyzing market prices and making informed bets on how prices are going to change. If the price of the asset goes up before the contract expires, the buyer can sell the contract for a higher sum so that another buyer can benefit from the lower price specified in the contract. However, if the price of the asset goes down, the buyer is still obligated to pay the higher price.
Futures traders operate through futures exchanges such as the New York Mercantile Exchange and the Chicago Board of Trade. All exchanges involve a clearing house, which is normally a large bank or financial services company that guarantees each trade by taking deposits from the traders. That’s called a margin and could be as high as 15% of the contract’s value. The Commodity Futures Trading Commission monitors all trading activity, reducing the risk of abusive trading and fraud.
Thinking about trading futures? Make sure you have enough cash saved up with a high-interest savings account.
James is an investor who thinks the price of coffee beans is going to go up in the next year. He finds a seller named Tonya and negotiates a futures contract with her that specifies that he’ll buy 100 tons of coffee beans at $100 per ton exactly one year from the date of signing. Nine months later, James sees that the price of coffee beans has actually gone up: it’s now $120 per ton. He finds a coffee beans trader named Alix and sells the contract to him for $11,000, $1,000 more than he would have paid for the coffee beans at closure. Three months later, when the contract closes and the beans are still $120 per ton, James has made $11,000, Tonya has made $10,000, and Alix has 100 tons of coffee beans that he acquired at below market rates.