What Exactly is a Futures Contract?

Looking to invest in a futures contact? If so, you should make sure you fully understand how future contracts work before you begin investing in them. If you look at the term, you can probably deduce two things. First, that futures involve the “future” and second that it is a contract. So what does that mean? More or less a buyer and seller will be obligated to conduct a transaction at prearranged prices at some future date in time.

The Basics of a Futures Contract

A futures contract obligates two parties, the buyer and seller, to conduct a specific trade at some point in the future. Futures are generally settled in cash. While the contract might call for the delivery of a good (oil, corn, gold), usually you can sell the contract on the market, or settle with the original seller in cash.

Also, you can sell the futures contract at pretty much any point to another buyer, who would then take over your obligation. The price that buyer pays would be based on the market conditions and projections at any given time.

A Corn Futures Example

Let’s say that a huge crop of corn from Argentina has flooded the market and corn prices have dropped. You believe, however, that in a few months the American government will pass a bill calling for the increased use of ethanol, which is distilled from corn.

Right now, the influx of corn has sent prices dropping. Futures for corn are currently selling for a very low price. You notice that corn futures with a six month expiration date are selling very cheap. Believing that corn prices will rise within that six months, you buy a contract for 10 metric tonnes of corn at $150 dollars per tonne.

Your insight turns out to be correct, and in four months the U.S. Congress passes a major bill calling for a dramatic increase in the use of ethanol. Demand for corn quickly rises, but because corn takes several weeks to grow, supply remains steady. This sends prices upwards.

You, however, already locked in the sale price several months ago at $150 dollars. The contract expires and on the expiration date corn is selling for $350 dollars per metric tonne. The original seller of the futures contract will now have to pay you the additional $200 dollars per metric tonne of corn. That amounts to a profit of $2000 dollars!

Futures and Speculation

Futures trading is highly speculative because parties are trying to predict future prices for a specific good. A lot can happen, however, from the time when a futures contract is first sold and when it expires. Indeed, a futures contract is basically a speculative bet for which way prices will go in the future.

Watch out for volatility

You might buy a futures for something that seems predictable, like wheat. However, a sudden flood of wheat from a surprisingly large crop in Australia could send prices spiraling downwards. Or a new fad diet calling for cutting wheat from ones’ diet could quickly became popular and send demand for wheat plummeting.

So if you plan to get involved in futures trading, you need to make sure you understand all of the risks. That doesn’t mean you shouldn’t get involved in such trading, however, because a lot of money can be made through futures. Generally speaking, the more risk in a particular investment, the more potential for profits.

High Risk, High Reward

Speculative assets like futures can be highly volatile, so the potential for profits can be very large. Of course, that also means that the risk of losses is also substantial. Understanding these risks is important for anyone who wants to buy a futures contract. This holds true even for an asset that seems safe, like corn. Speculation can send prices skyrocketing or plummeting.