What are Futures?

Submitted by Sharemarket News on 30 May, 2011 - 15:38

Everything about futures.

Futures, like options and warrants, are derivatives. Derivatives get their value from an underlying security or asset. However, unlike options, futures are contracts that give you the right as well as the obligation to exercise that right by a specified time period.

That's all good, but let's try to explain futures in simple English. Let's take trader X as an example, who likes subscribing to business publications. X pays for a two-year subscription to Stockz Or Bust magazine at $35 a year. Under the terms of agreement, X will get his magazines at a future date and at a set price even if publishing operating costs increases in the future. X has "hedged" against a rise in prices by paying for magazines at a set price that will be delivered in the future.

Futures contracts work in a similar way. But instead of magazines, say a cotton producer is looking for a price at which to sell his crop and a textile manufacturer is looking for a price at which to buy it, so he can figure out how many t-shirts to make and at what level of revenue.

Cotton producer and textile maker then enter into a futures contract with the following terms: Mr. Cotton promises to deliver 10,000 pounds of the crop to Mr. Textile at $1.00 per pound by the end of July. Note that not the actual cotton is traded, but the "agreement."

What happens now that the agreement has been made? Mr. Cotton and Mr. Textile have secured a price that they think is fair by expiration date. You'll notice two positions, Cotton going "short" (agreeing to sell goods not on hand) and Textile going "long" (agreeing to buy in anticipation of a rise in market prices).

So what does a futures contract contain? The terms and conditions are clearly stated, for one. You get the price per unit of product, product quality and quantity, the method and the date of delivery. The "price" of the futures contract, in case you're wondering, is the price that has been settled by both parties. In our example, this would be 10,000 pounds of cotton at $1.00 per pound.

How Futures Work: Hedging and Speculating

Unlike the stock market, futures market movements and contract prices are calculated daily. Let's go back to the previous example to illustrate. Instead of $1.00 per pound, the price of cotton suddenly rises to $2.00 one day after the agreement had been struck between Cotton and Textile. Since the day's gains and losses are recorded on the participant's account, this means Cotton's account is deducted $20,000 (10,000 x $2) while Textile's account is credited this same amount.

If either participant closes out or the expiry date is on the same day that the futures price rose to $2.00, this means Cotton has lost $1.00 per pound. The sad farmer is obliged to sell at a price under the current market value. Textile in the meanwhile, has bought cotton futures at a $1.00 discount to the current market price.

Remember that a contract was traded, not the actual cotton. Majority of futures transactions are settled in cash, while the actual physical commodity is traded in the cash market. Let's say that Textile goes home with his discounted purchase happy as a bee, while Cotton ventures into the cash market to sell more of his product. He sells one pound of cotton (the actual cotton this time) for $2.00, but receives only $1.00 in reality because of the loss on the futures contract. This is called hedging, where the loss is cancelled out or offset by the higher selling price in the cash market.

But let's suppose that instead of Cotton and Textile, two speculators, X and Y, trade cotton futures. At contract expiry or when either one closes out, X the short speculator loses $20,000 while Y the long speculator gains the same amount. Neither X nor Y traded cotton here or needed to go to the cash market.

Why Futures are Economically Important

  • Price Determinants. It's easy to see that supply of and demand for commodities is the foundation of futures contracts. Factors like political unrest, weather, environmental damage, and debt, among others, affect supply and demand, upon which rests commodity prices. The amount of a particular commodity available now and in the future determine market price.
  • Reducing Risks. When future prices are set to a specific value, there is a lower chance that producers will raise prices to compensate for profit losses. The participants in the futures contract also know the exact amount of commodity to buy or sell.