What is a Futures Contract?
A futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price. By purchasing the right to buy, an investor expects to profit from an increase in the price of the underlying asset. By purchasing the right to sell, the investor expects to profit from a decrease in the price of the underlying asset.
A financial analyst would profit from the right to buy if the price of the underlying asset increases. The investor would then exercise his right to buy the asset at the lower price obtained through buying the futures contract, and then resell the asset at the higher current market price. Investors profit from the right to sell if the price of the underlying asset decreases. The investor would sell the asset at the higher market price secured through the futures contract and then buy it back at the lower price.
Who Trades Futures Contracts?
There are two types of people who trade (buy or sell) futures contracts: hedgers and speculators.
These are businesses or individuals that use futures contracts for protection against volatile price movements in the underlying commodity.
A good example to illustrate hedging would be a corn farmer and a corn canner. A corn farmer would want protection from corn prices decreasing, and a corn canner would want protection from corn prices increasing. So, to mitigate the risk, the corn farmer would purchase the right to sell corn at a later date for a predetermined price, and the corn canner would purchase the right to buy corn at a later date for a predetermined price.
Each party takes a side of the contract. Both the farmer and canner hedge their exposure to price volatility.
Let’s look at the transaction from the farmer’s side. The farmer’s situation is that he’s worried that the price of corn may decline significantly by the time he’s ready to harvest his crop and sell it. To hedge the risk, in July he sells short a number of December corn futures contracts roughly equal to the size of his expected crop. December futures contracts are contracts to deliver the commodity in December. When he sells short in July, the market price of corn is $3 a bushel. The farmer is selling short corn futures in the same way that one can sell stocks short.
When December rolls around, the market price of corn has dropped to $2.50 a bushel. The farmer sells his corn for the going market price of $2.50 a bushel and closes out his futures contracts trade by buying the contracts back at the lower price of $2.50. Because he had sold short at a price of $3, he makes up the 50-cent market price drop through a 50-cent per bushel profit on his futures trade. If the farmer had not hedged his crop with futures contracts, he would have made 50 cents per bushel less for his corn crop.
In this case, the corn canner, who buys December corn futures in July, will lose 50 cents per bushel on his futures trade, but will benefit from being able to buy corn at just $2.50 a bushel in December in the open market.
In effect, both the farmer and the canner have used futures contracts to lock in a price of $3 per bushel in July, protecting themselves against a large adverse price change.
Speculators are independent traders and investors. Some trade using their own money and some trade on behalf of clients or brokerage firms. Speculators trade futures contracts just as they would trade stocks or bonds.
There are a few advantages that futures contracts have over other investments such as stocks and bonds:
- There is greater volatility within the futures market. On average, futures prices tend to fluctuate more than stock or bond prices. Although this also means greater risk, it provides traders with more opportunities to profit from short-term price fluctuations in the futures markets.
- Futures are highly leveraged investments. The trader typically only needs to put up 10%-15% of the value of the underlying asset as margin, but he can ride the full value of the contract as the price moves up and down. Thus, he can do more trading (trade larger amounts) with less money.
- Futures are harder to trade on insider information. That’s because normally there is no such thing as insider information on the weather or other factors affecting commodity prices.
- Commission charges on futures trades are small relative to other investments.
- Commodity markets are very liquid. Transactions can be completed quickly, decreasing the chances of market movement between decision and execution.
The Clearing House
In practice, a clearing house is used to facilitate futures (and all derivative) transactions by being on the other side of all trades. A clearing house is a financial institution formed specifically to facilitate derivative transactions.
When two parties enter into a futures contract, they are not actually entering into a contract with each other. Instead, both parties are entering into a contract with the clearing house. The clearing house acts as a guarantor by assuming the credit risk of transactions. However, the clearing house will not take on the market risk. Thus, gains and losses will be transferred to and from the clearing house to the respective parties’ accounts on a daily basis.
A Final Word
Futures contracts are considered an alternative investment, as they typically do not have any positive correlation with stock market prices. Commodity futures trading offers investors access to another asset class of investments. Futures trading offers advantages such as low trading costs, but carries greater risk associated with higher market volatility.
We hope you enjoyed this CFI article on futures contracts. CFI is the global provider of the Financial Modelling & Valuation Analyst (FMVA)™ designation. If you are looking to advance your career and expand your knowledge, check out the following additional CFI resources:
- Contango vs. Backwardation
- Hedging Arrangement
- Long and Short Positions
- Guide to Commodity Trading Secrets