1. Nature of Future Contracts
2. How Future Contracts Work
3. Types of Futures Traders

Future contracts are legally binding agreements to buy or sell something at a future date. They can be in respect of a commodity, currency, or any financial instrument. These contracts are usually made in a futures exchange, and the price of the asset in question is determined at the time of the contract.

Nature of Future Contracts

A futures contract is a standard form contract, but the exact details vary depending upon the commodity the contract pertains to. It specifies the quantity and quality of the asset being sold or bought. The buyer and the seller are both under an obligation to buy or sell the commodity at the predetermined price on the set date.

How Future Contracts Work

The asset traded in a futures contract can be a commodity, foreign currency, stocks, bonds, and other financial instruments. Commodities that have been traditionally traded include gold, silver, grain, oil, and natural gas.

A futures contract may or may not require physical delivery of the commodity; sometimes, the parties fulfill the contract by settling the difference in price of the asset.

A futures contract is often referred to simply as "futures." For example, you can just say that you bought sugar futures instead of saying that you entered into a sugar futures contract. The future date on which the asset is to be delivered in exchange for the payment is called the delivery date. The buyer is said to have a long (position) and the seller a short (position) in a futures contract.

An exchange plays the role of a mediator and facilitates easy buying and selling of commodities. It provides safety for a futures contract. All futures contracts pass through the clearing house of an exchange. All futures buyers and sellers must register with the Commodities Futures Trading Commission, which is the regulating authority for the commodities future exchange. Some of the popular futures exchanges for commodities in the U.S. include the Chicago Mercantile Exchange, the New York Mercantile Exchange, and the Chicago Board of Trade.

You can also interchange futures contracts provided they are for the same commodity and quantity and are deliverable in the same month and location. This is called fungibility. It allows you to buy and then sell the same futures contract before the date of delivery. It is for this reason that futures are a part of derivatives.

When the parties enter into a futures contract, the exchange requires them to put a nominal account as margin. As futures prices change every day, the price difference is settled daily from this margin. If the margin gets exhausted, the parties must replenish the account. This process is technically known as marking to market. At the time of delivery, it's only the price difference of the day that remains to be settled since all the previous days' differences will have been already settled.

Types of Futures Traders

There are basically two types of futures traders:

  • Hedgers
  • Speculators

Hedgers

  • Hedgers do not trade futures with profit making in mind; their intention is to stabilize their business operations by hedging against future losses.
  • Their profits and losses from a futures contract are usually from the change in prices of the physical commodity.

Let's say, for instance, you'll have 50 tons of apples in your orchard next year. Now you can either sell the apples next year after harvesting them or you can lock the selling price now by entering into a futures contract to sell the apples at a predetermined price. When you choose the latter option, you hedge yourself against the fall in apple prices next year. However, even if apple prices increase next year, you'll only get the contracted price.

Similarly, if you are an apple juice manufacturer, you may want to purchase apple futures to reduce the uncertainty of apple prices next year. Depending upon the actual prices at the time of delivery, you may end up overpaying or underpaying for the apples.

Speculators

  • Speculators, on the other hand, are least interested in taking physical delivery of the assets.
  • Their sole intention is to make profits by speculating on the future prices of an asset. If their prediction turns out right, they end up making a profit.
  • When the market price of the commodity increases, they can sell the futures contract to someone else and can avoid taking delivery in the physical form.
  • Although often for price fluctuations, speculators provide the much-needed liquidity in the market.

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