A futures contract is a derivative instrument (i.e., an instrument whose price is based on the price of an underlying financial security) contract in which two parties consent to trade a financial security or physical commodity for future delivery at a stipulated price. In other words, the buyer of a futures contract agrees to purchase the security or commodity at a date in the future for a predetermined price. This does not imply that parties will necessarily send or receive large quantities of commodities. Some traders in the futures market use the contracts to hedge risk (actual delivery of commodity may occur), while other traders speculate similar to forex trading.
The futures market is highly liquid and offers a centralized platform for traders globally but due to the intricacies involved and the speculative nature, it is not an instrument for the weak-hearted!
How do Futures Contracts Work?
A futures contract or simply futures is similar to any other contract. To simplify, consider the example of a rental lease. The landlord (seller) agrees to provide his house to the tenant (buyer) for one year starting January 2012 (future delivery) at a set rent (stipulated price). The landlord secures a tenant for their home (product) at a fair price that he thinks is justified after considering market factors (evidently, unpredictable to a certain degree); the tenant has reduced their market risk (e.g. housing demand) of rent increases by signing the contract.
Now, extend this example to various commodities such as crude oil, natural gas, gold, silver, platinum, wheat, soybeans, corn, cocoa, sugar, etc. and you have commodity futures contracts. Futures are also available for financial instruments, where a loan-seeker can lock in interest rates to hedge against rising interest rates.
The producer (farmer, miner, etc.) of these commodities is the seller and the processor (not the end-user or consumer but an intermediary that needs the raw material for a variety of purposes) of these commodities is the buyer. The seller of the commodity has a short position, while the buyer has a long position. In the case of commodity contracts, the quality and quantity of the product are specified along with the method of transportation, in addition to the above-mentioned price and date considerations.
Hedging vs. Speculation
As mentioned earlier, the futures market houses both hedgers and speculators. A hedger (buyer) uses futures to fix the price of their commodity of interest for delivery at a future date and mitigate price risks. However, the seller of the commodity would want the maximum price possible; the futures contract offers price certainty to both parties by minimizing impact of market price fluctuations. E.g. a fuel ethanol manufacturer may want to lock the price of corn that they need in 2012 by buying a futures contract (a farmer is the counterparty) for settlement on January 5, 2012 at 640 cents per bushel.
If the market price in January rises to 680 cents per bushel, then the fuel ethanol manufacturer would have got a good deal because of their futures contract. If the price falls to 600 cents per bushel, then the manufacturer would have been better off without the contract. Nonetheless, the hedging through the contract helps the manufacturer guard against future uncertainties.
Conversely, a speculator tries to profit from the uncertainties that exist in market conditions and the subsequent futures contract price variations. In other words, they hope that the event, which the hedging buyer is trying to guard against occurs. Using the same example above, a speculator would hope that the price of corn would rise, so that they could sell their contract at the higher market price – they take on the risk in the hope of a significant reward. As with options, as the time of delivery (expiry) nears, the contract price becomes steadier, since better applicable data about market supply and demand would become available.
Have you traded futures? Did you buy/sell futures contracts for hedging or as mere speculation?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.