Futures

What it is:

Futures are financial contracts giving 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:

Futures are also called futures contracts.

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 ev 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.

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 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.

Futures exchanges depend on clearing members to 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.

Regulation
The Commodity Futures Trading Commission (CFTC) regulates commodities futures trading through its enforcement of the Commodity Exchange Act of 1974 and the Commodity Futures Modernization Act of 2000. The CFTC works to ensure the competitiveness, efficiency, and integrity of the commodities futures markets and protects against manipulation, abusive trading, and fraud.

Futures Exchanges
There are several futures exchanges. Common ones include The New York Mercantile Exchange, the Chicago Board of Trade, the Chicago Mercantile Exchange, the Chicago Board of Options Exchange, the Chicago Climate Futures Exchange, the Kansas City Board of Trade, and the Minneapolis Grain Exchange.

Why it Matters:

Futures are a great way for companies involved in the commodities industries to stabilize their prices and thus their operations and financial performance. Futures give them the ability to "set" prices or costs well in advance, which in turn allows them to plan better, smooth out cash flows, and communicate with shareholders more confidently.

Futures trading is a zero-sum game; that is, if somebody makes a million dollars, somebody else loses a million dollars. Because futures contracts can be purchased on margin, meaning that the investor can buy a contract with a partial loan from his or her broker, futures traders have an incredible amount of leverage with which to trade thousands or millions of dollars worth of contracts with very little of their own money.

Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.