Futures contracts are financial assets just like stocks and bonds, but with some important differences. These differences are what make futures such an appealing investment for traders. Many tend to think that futures are too complicated to understand and consequently, miss many opportunities by not trading them. However, there is a simple but true formula that applies to futures trading as surely as it does to trading in stocks, bonds and real estate. Money is made if one buy low and sell high. With futures, one can sell before he buys, so the simple rule can also read: sell high and buy back low.
In the simplest terms, a futures contract is an agreement in which a buyer and a seller agree to consummate a transaction at a predetermined time in the future at a price agreed upon today.
Consider the case of the farmer who estimates that it will cost $1.50
per bushel to grow corn and also that the crop will be 100,000 bushels
during the summer. The farmer can enter into a contract with a buyer to
sell the anticipated 100,000 bushels of corn at a price that represents
a profit before the crop is even planted.
So the contract stipulates that the farmer will sell 100,000 bushels
to the buyer for $2.00 per bushel on September 1 which is 5 months later,
regardless of the price of corn at that time in the cash market. The cash
market, also known as the spot market is the price at which corn is being
sold on that day for immediate delivery. If the farmer does grow 100,000
bushels and the price of the corn does turn out to be $1.50 a bushel, then
the farmer will have a profit of $50,000 (100,000 bushels X $0.50)
With a futures contract, the underlying merchandise is known. For example,
you can buy a futures contract on gold, lumber, pork bellies, swiss
francs, and many other items. The underlying item or commodity is
described specifically in the contract specifications which are determined
by the futures exchange on which it trades. The full price of the
commodity must be paid only upon contract expiration at which point
the trader takes delivery, if one bought futures, or makes delivery,
if he sold futures, of the underlying commodity. Finally, transactions
in futures can only be done on futures exchanges. These exchanges
are located primarily in Chicago and New York.
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