A futures contract is quite literally just that. It’s a financial derivative that is a contract between two parties who agree to transact a security or commodity at a fixed price on a set date in the future. It is a contract for a future transaction, which we simply coin as “futures.”
Most futures contracts do not actually result in the delivery of the underlying security or commodity. Most futures transactions are purely speculative, so it’s an opportunity to profit or hedge and not usually used to take delivery of the physical good or security.
There are many types of futures contract to trade. They include:
Agricultural, Energy, Equity Index, FX, Interest Rates, Metals, and more
The futures market is centralized, meaning that it trades in a physical location or exchange. There are several exchanges, such as The Chicago Board of Trade (CBOT) or the CME, where you have futures exchange floors. Trading here is done in “pits,” which are enclosed places designated for each futures contract. These are the same “pits” you have seen on TV where a lot of shouting, hand signals and paper waving take place.
These “pits” are a far cry (no pun intended) from days gone by, and retail investors and traders can have access to futures trading electronically (through a broker) from the comfort of their own home or business. The key word in that last sentence was “broker”. He is your middle man between your computer and the exchange. You cannot trade futures without one, so choosing a reliable broker as well as a good reliable data feed is paramount. More on that later.
Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel: An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price. A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices. Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.
In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it’s the basis of their business. They use the futures market to manage their exposure to the risk of price changes.
But not everyone in the futures market wants to exchange a product in the future. These people are investors or speculators (you and me), who seek to make money off price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they’re just in the market to wager on price movements.
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