The term ‘futures contract’ is used to describe the arrangement between a seller and a buyer concerning a transaction scheduled for the future. The buyer agrees to purchase a specific asset that the seller promises to provide at the agreed upon price.
An arrangement like this can be either very advantageous or severely debilitating depending on many factors, some of which seem to be at the mercy of fickle fortune. So why would anyone want to make an arrangement like this?
How Futures Contracts Work
To understand the reason this can be useful, it is important to understand all the underlying factors at play, the best place to begin is with the assets that are most often exchanged with this sort of contract.
These are the usual commodities that you will find being exchanged such as bonds, natural gas, Crude Oil, grains, gold, orange juice and other traditional commodities.
The Futures Contract
The easiest way to define futures contract is an agreement made, usually on the trading floor of a future exchange, between the buyer and seller to exchange a specific commodity for an agreed upon price at a predetermined date.
The date for the transaction is always very important to the commodity being exchanged. These contracts are standardized so that they are valid on the futures market. Furthermore, they will often include criteria as to the quality and quantity of the commodity being traded. Sometimes the contract will include specifications for the delivery of the asset or commodity, others have provisions that allow for cash settlement, and so forth.
The terms ‘futures’ and ‘futures contracts’ are used interchangeably and essentially refer to the same thing. It is common to hear a phrase like “... those gold futures really paid off.”, which is to say ‘gold futures contracts’.
To but a finer point on the subject, it could be said that a ‘futures contract’ refers to the specifics of an agreement and the commodity being traded. “Futures” is used more generally and can refer to the entire market.
There are two types of traders that frequent the futures market; these are hedgers and speculators.
Hedgers — are not in this market to gain a profit directly but rather to ensure that their future revenues are safe from major market fluctuations. They are more concerned about making sure the market that supplies an important physical commodity is not going to suddenly go berserk.
Another good way to define futures contract is with a simple example. Let's imagine, you are a hedger and also a farmer; you now have another way to sell your wheat or corn. Instead of simply taking them to the market you can make a future contract.
This means you can sell the grains you plan to grow next year and lock in satisfactory price right here and now. So you take out a futures contract that says you will sell 50 tons of corn to a buyer at an agreed upon price.
The advantage is this, if the prices of corn falls because there was an abundant crop of corn that year, you will have floated your prices and secured a good paycheck. On the other hand, if there is a bad growing season next year, prices may go up, which means not only will you be getting lower-than-market prices, but have to deliver 50 tons of corn that cost more to go and buy at market prices.
Another type of hedger would be the owner of a candy company, who will be the buyer in this scenario. This hedger will want to secure favorable prices and control future production costs. The possibilities are that things go well and he/she ends up underpaying for cocoa to make the candy, otherwise they will be paying more - but still within their ‘acceptable’ projections.
Speculators — are not interested in the controlling the assets and commodities they are buying or selling. These guys are here for the game of chance. By placing bets for or against the expected market projections they can potentially walk away with hefty winnings.
For example, if everyone is expecting that the prices of cocoa will decrease dramatically next year, the savvy speculator may have reason to disagree and will take out a futures contract. Next year when the prices of cocoa suddenly rises, the speculator can make considerable profits from selling his/her futures contract quickly before it expires — or they will have 50 tons of cocoa and not know what to do with it..
Speculators can often be blamed for major price fluctuations, but they do keep some fluidity in the futures market which keeps things interesting.
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