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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Futures Contract

What it is:

Futures contracts give the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time.

How it works (Example):

The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets.

There are two kinds of futures traders: hedgers and speculators. Hedgers do not usually seek a profit by trading commodities futures but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the market for the underlying physical commodity

For example, if you plan to grow 500 bushels of wheat next year, you could either grow the wheat and then sell it for whatever the price is when you harvest it, or you could lock in a price now by selling a futures contract that obligates you to sell 500 bushels of wheat after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if the season is terrible and the supply of wheat falls, prices will probably rise later -- but you will get only what your contract entitled you to. If you are a bread manufacturer, you might want to purchase a wheat futures contract to lock in prices and control your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat depending on where prices actually are when you take delivery of the wheat.

Speculators are usually not interested in taking possession of the underlying assets. They essentially place bets on the future prices of certain commodities. Thus, if you disagree with the consensus that wheat prices are going to fall, you might buy a futures contract. If your prediction is right and wheat prices increase, you could make money by selling the futures contract (which is now worth a lot more) before it expires (this prevents you from having to take delivery of the wheat as well). Speculators are often blamed for big price swings, but they also provide a lot of liquidity to the futures market.

Futures contracts are standardized, meaning that they specify the underlying commodity's quality, quantity and delivery so that the prices mean the same thing to everyone in the market. For example, each kind of crude oil (light sweet crude, for example) must meet the same quality specifications so that light sweet crude from one producer is no different from another and the buyer of light sweet crude futures knows exactly what he's getting.

The ability to trade futures contracts relies on clearing members, which manage the payments between buyer and seller. They are usually large banks and financial services companies. Clearing members guarantee each trade and thus require traders to make good-faith deposits (called margins) in order to ensure that the trader has sufficient funds to handle potential losses and will not default on the trade. The risk borne by clearing members lends further support to the strict quality, quantity and delivery specifications of futures contracts.

Why it Matters:

Futures trading is a zero-sum game; that is, if somebody makes a million dollars, somebody else loses a million dollars. The downside is unlimited. Because futures contracts can be purchased on margin, meaning that the investor can buy a contract with a partial loan from his broker, traders have an incredible amount of leverage with which to trade thousands or millions of dollars worth of contracts with very little of his own money. Further, futures contracts require daily settlement, meaning that if the futures contract bought on margin is out of the money on a given day, the contract holder must settle the shortfall that day. The unpredictable price swings for the underlying commodities and the ability to use margins makes trading futures a risky proposition that takes a tremendous amount of skill, knowledge and risk tolerance.

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