As the name suggests, a futures contract (more commonly known as futures) is a legally-binding contract to buy or sell something on a specific date in the future at a predetermined price.
Futures were originally designed for agricultural goods such as wheat and milk, expanding to more commodities like oil, and then eventually a wide-range of financial instruments. Now, futures cover the likes of currency, interest rates and stock market indices. While some require the physical delivery of goods, most nowadays are settled in cash.
A simple example of a futures contract can be demonstrated between a dairy farmer and a bakery. A dairy farmer agrees to sell a certain volume of milk to the baker in six months' time at 100p per litre. When the pre-agreed date arrives, known as the delivery date, the farmer will deliver the milk, and the baker would pay the farmer 100p for each litre.
Why do futures exist?
It’s primarily to handle risk. Commodity prices can be volatile, and both the buyer and the seller want to mitigate against price fluctuations.
The dairy farmer is assured he will get an acceptable price for his milk in six months’ time, even if the spot price of milk drops in the meantime. The baker knows he can secure the milk he needs to make his products at an acceptable price in six months’ time, even if the spot price of milk rises in the meantime.
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Conversely, this also means that both the buyer and the seller can miss out on extra profits if the price goes in their favour. If the spot price of milk has risen to 300p per litre on the delivery date of the futures contract, the farmer still needs to sell the milk to the baker at the agreed price of 100p per litre; therefore, he'll miss out. Under this scenario, the baker has managed to protect himself from a large rise in milk prices using the futures contract, while the farmer has not maximised profits.
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Who uses futures?
On futures exchanges, the buyer of a futures contract is holding a long position and the seller is holding a short position. There are predominantly two types of people involved in futures trading on exchanges, those that use futures to hedge against other trades, and those that use them to speculate.
As futures are traded on exchanges, investors and traders make up the third party in the contract, alongside the dairy farmer and the baker. Both the baker and the farmer sign individual contracts with the investor.
For example, the predetermined price for the two contracts (one between the investor and the farmer, and one between the investor and the baker) is 300p per litre. If the spot price of milk falls to 100p then the investor agrees to pay the difference of 200p. If the spot price rises to £5, then the investor pockets the difference of 200p.
Ultimately, the investor has taken on all the risk from the farmer and the baker, who have secured predictable prices that give them security and the tools needed to plan effectively.
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Those hedging tend to be those involved in using or producing the underlying asset. They are hedging against the spot price. If you gain from the futures contract, you have lost in the spot market. Futures allow them to offset gains against losses.
Speculators are looking to buy the underlying asset through a futures contract in the hope the spot price will rise in the future, when it can be sold for a profit. Speculators can also profit from any favourable price margin under a cash settlement.
But, as always, they can lose out in the same way if the price falls after they enter the contract. This is why some choose to short, by selling the asset in the hope it will fall and they can buy it back at a cheaper price, profiting from the difference.
Futures vs forwards contracts: what’s the difference?
Futures contracts and forwards contracts play very similar roles and play by the same rules, but with some fundamental differences.
Futures contracts are traded on futures exchanges, while forwards contracts are traded over the counter (OTC).
Futures are a standardised form of forwards contracts, specifying the quality and quantity of the underlying asset that is to be traded.
When parties enter a futures contract, the predetermined price that the buyer will pay to the seller is based on the prevailing futures market price at the time the contract is entered. The price agreed under a forwards contract, however, can be privately negotiated.