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Understanding a Futures Price
When a trader buys a futures contract, the price represents the price at which the trader is committed to buying the underlying commodity when the futures contract expires. Similarly, when the trader sells a futures contract, the price represents the price at which he is committed to selling the underlying commodity when the futures contract expires. (Not all futures contracts require physical delivery upon expiration, some are simply settled by cash.)
For example, if A buys a COMEX December gold futures at $380 per ounce, then A has the obligation to buy 100 ounces of gold at a price of $380 per ounce in December when the futures expires. (COMEX, which stands for the Commodities Exchange in New York, is the futures exchange on which gold futures trade. COMEX has set the quantity of gold underlying the contract at 100 ounces.) The price of gold futures constantly fluctuates in response to several factors such as supply and demand, interest rates, and prices of other precious metals. However, no matter what the price of gold does after A buys the futures, he will be able to buy gold at the price of $380 per ounce - he has locked in this purchase price.Futures prices are often different than cash prices for the same commodity. One may find in some cases that futures prices are consistently above cash prices, in which case the futures are said to be trading at a forward premium, or he may find that futures prices are consistently below cash prices, in which case the futures are said to be trading at a forward discount.
Price limits
Some futures markets have daily price
limits that restrict prices from moving by more than a prescribed amount
from the previous day's settlement price. These limits are determined by
the futures exchange (with Commodity Futures Trading Commission approval)
on the basis of variations experienced in the underlying cash markets,
and are meant to serve as circuit-breakers when trading becomes especially
volatile. If prices reach the upper or lower limit, trading is suspended
for a period of time, referred to as the cooling off period, that may last
anywhere from several minutes to the remainder of the trading day. The
cooling off period helps to discourage panic buying or selling. Following
this period, price limits are usually expanded and trading may resume.
Price limits are adjusted from time to time as price volatility changes. In some commodities, the nearby contract month trades without limits for a short period before its expiration. It is important to be aware of the existence of any price limits for the futures contracts that one trades as trades may be difficult or impossible to execute if prices move to the limit and stay there - a condition referred to as locked-limit. This information can be found in the contract specifications.
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