What are futures?
Futures contracts, commonly known as futures, are purchasing contracts that obligate buyers and sellers to complete transactions in the future at prices they set now. Assets traded through futures contracts include both physical commodities and financial instruments. Sometimes, in what’s called speculation, the contract itself is sold, especially when the actual price of the asset exceeds the futures price the buyer originally agreed to.
In many cases, futures traders never sell or receive the underlying asset of a futures contract, as they are only interested in making money on the asset’s price. The parties to the contract either hold the short position, which is the agreement to sell, or the long position, which is the agreement to buy.
Futures traders fall into two main categories: hedgers and speculators. Hedging is a way of minimizing potential loss, arising 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.