What are Futures?
To define the futures market, you must understand the concept of the “Futures Contract”. This form of investment is built around buying and selling financial instruments at a later date. Commodities are the most common financial instruments in futures trades. In this context they are raw physical products like gold, wood, corn, and other unprocessed material. Futures contracts can also involve intangible financial instruments like currencies or price indices.
Consider this example:
Susan and William enter into a futures contract. William acquires 1,000 pounds of coffee from Susan on Aug. 1st at $1 per pound. Under the agreement, Susan will acquire 1,000 pounds of coffee on the next Aug. 1st. William will then buy the coffee beans from her at $1 per pound.
Elements of a Futures Contract
1- Long vs. Short Positions
All futures contracts have two sides: a buyer and a seller. The party that enters a contract to buy is taking a long position while the seller takes a short position. In our example, William is taking a long position while Susan is in a short position.
2- The Settlement Date
In futures contracts, the settlement date is the date of the transaction. In our example, the settlement date is Aug. 1st.
3- Physical Settlement vs. Cash Settlement
Traders in futures contracts develop two types of settlement. The physical settlement involves the delivery of goods. In our example, the physical settlement involves Susan delivering the coffee beans to William. In a cash settlement, the players will trade the cash value of the contract. William and Susan will not buy any beans; one party will pay the other based on the price of coffee relative to the strike price.
4- The Strike Price
A strike price is the agreed-upon price of a particular transaction. From our example, the strike price is $1 per pound. It is the price at which a short trader is willing to sell a commodity to a long trader. Regardless of the state of the market, the strike price remains constant. The fixed price is the factor that makes futures trading so attractive.
How Futures Trades Work
Investors trade futures contracts to speculate on the market. A correct prediction of a commodity’s prices can earn an investor a lot of money. They earn this money by buying an asset for less than its market value and selling it for more.
From our example, William is betting that the price of coffee will rise. Let’s say that on Aug. 1st coffee sells for $1.10 per pound. William can buy the commodity from Susan and resell it to make a 10-cent profit.
In a cash settlement, William will collect the difference between the market price ($1,100 for 1,000 pounds) and the strike price ($1,000 for 1,000 pounds) from Susan. Bill makes $100.
What happens when the market goes against Willian’s prediction?
Let’s say that on Aug. 1st coffee sells at $0.9 per pound. William will buy the coffee from Susan at $1 per pound. In this transaction, Willian makes a loss of $100. Susan collects this money from William.
Real-life investors operate on massive scales. They buy and sell millions of units. The futures market can turn a nickel into a fortune and a fortune into massive debt.
In the often uncertain world of agriculture, traders developed futures contracts to stabilize commodity prices.
From our example, let us assume that William and Susan are not investors. William owns a chain of coffee shops, while Susan is a coffee farmer. Each player wants to score the best price of coffee. Above all, both parties are looking for stable prices.
Susan does not want to end up with a warehouse full of almost worthless coffee come Aug. 1st when the prices drop. William has to avoid the opposite risk.
In this case, both William and Susan can use futures contracts to hedge themselves from price fluctuations. Susan accepts the risk that she may miss out on potential gains, and William is avoiding the possibility of overpaying once the prices skyrocket.
How to Trade Futures
The Commodity Futures Trading Commission (CFTC) regulates the futures markets. This authority is a federal agency that was created by Congress in 1974. The mandate of the CFTC is to ensure the integrity of futures market pricing. The agency also prevents trading malpractices and fraud. The CFTC is the regulatory body that governs brokerage firms that deal in futures trading.
Choosing a Futures broker
You need a broker to trade futures contracts. Stockbrokers offer access to the exchanges and markets that deal in futures. Finding the right broker can be overwhelming. At MyTrade, we take the confusion out of your financial journey. Check out our broker reviews to find the right futures broker for you.