What is a futures contract?
A futures contract is a binding agreement between two parties, where they both agree to buy and sell an underlying security at a predetermined price at a specified date in the future.
The buyer signs an agreement and takes the obligation of buying an underlying asset once the futures contract expires. The seller absorbs the responsibility of providing the underlying asset upon the expiry date.
The buyer in a futures contract holds what is often referred to as a long position or hold position, while the seller is said to be in a short position. The exchange acts as the mediator to ensure that all the terms of the futures contract are honoured. Some of the assets commonly traded with futures contracts include commodities, stocks, bonds, and precious metals.
Given that prices of underlying assets change every day, the differences in prices in futures contracts are often settled daily from the margin. If the margin is used up, the party involved in the futures contract must replenish their margin in a process commonly referred to as marking the market.
Futures contracts are standardised, which makes it possible for prices to mean the same thing to everyone in the market.
In futures contracts there are two types of traders: hedgers and speculators.
Hedgers engage in futures contracts not to profit, but to stabilise the revenues and costs associated with their businesses. The gains and losses that such futures traders incur are often offset by a corresponding loss or gain in the market and that of the underlying physical security.
For example, a farmer who wishes to grow 300 bushels of wheat could opt to grow the wheat and then sell it at the prevailing market price upon harvest. Alternatively, the farmer could opt to lock in a given price by entering a futures contract that obliges her to sell the 300 bushels and wheat at a predetermined market price.
The hedging process allows the farmer to avoid losses should the price of wheat drop once the wheat is ready for sale. Conversely, the futures contract could prevent her from enjoying the benefits of a higher price should it rise above the predetermined price.
Speculators are futures contract traders not interested in owning any underlying security they are trading. Such traders only place bets on what would be the price of certain commodities.
Speculators who disagree that the consensus price of an underlying commodity will fall buy a futures contract. Should prices rise, these traders are usually able to sell their futures contract at a much higher price, thus making money on the price difference.
While speculators are usually the cause of big price swings in the market, their actions most of the time lead to desirable levels of liquidity in the futures market.
Futures trading is a zero-sum game, which means that someone’s gain is usually another person’s loss. In other words, one trader making a $1 million profit translates to a loss of $1 million for another trader.
Some of the popular futures markets include the Emini S&P 500 index traded in the CME, as well as the Emini Dow Jones Industrial Average. Some of the commonly traded currency futures include the EUR/USD and GBP/USD currency pairs on the CME. Some of the most frequently commodities traded on the CME include gold, silver, and oil futures.