What is a Futures Contract?

Commodities have a cash price at which they can be bought and sold on the open market. The trouble is, it is volatile. Storms, droughts, government decisions, wars – all can and do cause large price fluctuations.

Farmers who grow crops, and commercial enterprises that use those crops as raw materials, realised long ago that they needed a better pricing mechanism to manage their businesses. Just relying on the current cash price left them too exposed to unexpected price movements. They needed to know, in advance, what price their crop would be traded for, so they could run their businesses better. The futures contract was developed as a tool for these entities to manage risk and reduce uncertainty in their business activities.

Futures contracts are based on a standardised unit of some commodity. For example, 5,000 bushels of No. 2 yellow grade soybeans.

The range of contracts available soon expanded beyond agricultural crops to include other commodities such as energy and metal products.

Other contracts are based on artificially created commodities. For example, “5 times the Dow Jones index”. (If the Dow Jones Index is 10,000 then this contract value would be $50,000.)

The only criterion that the underlying commodity unit has to meet is that it is unambiguously defined.

A futures contract is either a commitment to buy (LONG) or to sell (SHORT) the standard unit of the commodity at a specified future date.

There is no requirement to own the commodity before entering a short contract. This sometimes confuses people. How can I sell something I don’t own? The answer is that it is a futures contract. When you go short, you are committing to sell at a future date, not now.

Of course, if you don’t own the underlying commodity at the moment, you will need to buy it before the contract expiry date. Alternatively you could enter a long contract to cancel out the short position.

It is mainly commercial operators that plan to hold futures contracts through to delivery dates. This enables them to fix prices in advance, making it easier to manage their businesses.

Futures contracts are not personalised and can be bought and sold on a futures exchange. The prices at which the contracts are traded vary as the value of the underlying commodity fluctuates.

Speculators buy and sell futures contracts depending on their view of the price movement of the underlying commodity. They do not hold them until the contract expiry date, because they have no wish to deliver or take delivery of the commodity.

A speculator enters a long trade by buying a contract, and exits the trade by selling it. This is profitable if the value of the underlying commodity increases. For example, if soybeans increase in price by $0.02 per bushel, the contract value increases by $100 (5,000 X $0.02).

A speculator enters a short trade by selling a contract, and exits the trade by buying it back. This is profitable if the value of the underlying commodity decreases. For example, if a trader shorts the futures contract based on the Dow Jones index just before it falls 30 points, the contract value decreases by $150 (30 X 5). The trader buys it back at the lower price to realise the profit.

Contracts are traded on futures exchanges around the world. A large US exchange is the CME Group which was formed by the merger of the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). Look under the Products links on this web site to see the range of contracts available and to examine the contract specifications.

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