Basics of Futures and Futures Contracts
What are futures
In the United States, trading futures began in the mid-19th century with the establishment of central grain markets. Where farmers could sell their products either for immediate delivery, also called the spot or cash market or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner of today’s exchange-traded futures contracts.
How future contract works
A futures contract can protect producers and suppliers from the fluctuations of price rates. Suppose, Bob's ice cream buys milk from Tom's dairy to make its ice cream. The price is $2 per gallon at the brisk price. Tom profits from the milk it sells and Bob's profits on every ice cream cone it sells.
One day a new dairy open and the number of cows doubles. The extra milk pushes the price of milk down to one dollar a gallon. Bob is making more profit as costs drop. But Tom is losing money. Later a sleeping sickness knocks out three-quarters of all the cow. Thre milk rate rises to $4 and Bob's profit per ice cream disappears.
Both companies want to avoid this price volatility. They both meet with an investor. Each company negotiates a separate contract with the investor. For Tom's dairy, the contract states that if the price of milk goes below $2 the investor agrees to pay the difference to Tom. If the price goes above $2 the investor gets to keep the profits. Bob contract with the investor works the opposite way. If the price of milk goes above $2 the investor pays the extra money and Al's gets milk at a predictable $2. If the price dips below $2 Bob still pays $2 and the investor collects the profits by locking in the price of milk. A futures contract allows both Bob and Tom to transfer their potential risks and rewards on to the investor.
Who trades futures
Conventionally, traders are divided into two main categories, hedgers, and speculators. Hedgers use the futures market to manage price risk. Speculators, on the other hand, accept that risk in an attempt to profit from favorable price movement. While futures help hedgers manage their exposure to price risk, the market would not be possible without the participation of speculators. They provide the bulk of market liquidity, which allows the hedger to enter and exit the market in an efficient manner.
Speculators may be full-time professional traders or individuals who occasionally trade. Some hold positions for months, while others rarely hold onto a trade more than a few seconds. Regardless of their approach, each market participant plays an important role in making the futures market an efficient place to conduct business.
Why trade Futures
Futures provide a fast and cost-effective way for you to access financial and commodity markets around the clock. Increased interest in global markets, has accelerated media attention and attracted the interest of traders from around the world. From their study of the markets, traders develop a perspective on the direction of commodity prices, energy prices, metal prices, currencies, interest rates and stock indexes.
Future Contracts can be conducted in any financial market. Whether you're an experienced or efficient in markets like currencies, stocks or commodities, you can consider trying them with futures contracts rather than spot trading. Who knows, this may bring you the new strategy of trading. Alongside some large sum of profits.
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