A futures contract is a standardized and legally binding agreement between two parties to execute a trade on certain terms at a specific future date. Such agreements serve many purposes and can help you hedge financial risks and also profit from market swings. Understanding how futures differ from cash transactions is essential if you wish to make sense of financial markets.
Simple Forward Contract
If you ever put down a deposit on a car or a house for a future purchase, you have executed a forward agreement. Such agreements are essentially contracts to trade something at a predetermined price and future date. The goal is to secure a transaction and lock in the future price to eliminate risk for both sides. A typical "forward" might be between a corn producer and a cereal manufacturer to trade 1,000 pounds of corn in six months at a specific price per pound. Such an agreement helps both parties budget with ease and eliminates the risk of not being able to find a party to buy from or sell to. Paying for corn on the spot for immediate delivery, on the other hand, is known as a cash trade.
Futures contracts are simply standardized versions of forward agreements. A large cereal manufacturer might buy corn from more than 100 farmers, making it tedious to sign agreements with each one. To streamline the process, large exchanges, such as the Chicago Board of Options Exchange, offer standardized agreements for commodities such as corn. Corn delivery might take place on the first and 15th of every month, and each contract might be for 1,000 pounds. The specifications of corn would also be set, while the prices at which corn will change hands can go up and down in 5 cent increments per pound. A cereal manufacturer may thus buy 50 contracts for June 1 at, say, $1.35 per pound, locking in a supply of 50,000 pounds.
Futures contracts allow traders to gain from price swings in the commodities markets. If you think corn will appreciate in value, you could buy corn futures for delivery in six months for 10,000 pounds of corn at $1.35 per pound. In the futures market, you can engage in such a trade without ever having to touch the corn. If you are right and corn is trading at $1.45 in six months, you can transfer your contract for a profit. The standardized contracts in the futures market are as easy to transfer as stocks or bonds. Benefiting from a rise in corn prices by way of cash transactions, however, would involve buying and storing corn, which is impossible for most investors.
Another advantage of the futures market is the relative lack of risk. Since trades go through an exchange and brokerage firms, there is practically no chance of fraud. Even when paying cash for corn on the spot, the amount of product delivered to your warehouse or the exact quality may not match the agreements. With standardized contracts, however, both the exchange and brokers monitor the transaction, ensuring a fair deal for all parties.
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