What is a Futures contract?

Futures contracts can seem complicated at first, particularly when you read the legal definition! But, don’t worry, actually trading them is very straightforward. Ultimately, when you look at your trading screen, you are seeing the price of an asset (for example Gold), deciding if you think the price will go up, if you think it will… you buy a contract.

If it goes up, you make money, if the price goes down, you will lose money.

One of the great features of futures contracts is that you can also profit if you think the price is going down. This is known as taking a short position. So, if you think the price of Gold is going down, you can sell a Gold contract, and buy it back sometime later when the price has declined, and make money! 

The legal definition of a futures contract

A futures contract is a legal agreement to buy or sell a particular commodity, or security, at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity and are traded at a centralized marketplace, known as a futures Exchange. 

How Futures contracts work for hedgers

The buyer of a futures contract is taking on the obligation to buy and receive the underlying commodity when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying commodity at the expiration date. 

Futures contracts exist to allow producers and consumers of those products to hedge against price movements before they are ready to deliver (the producer) or take delivery (the consumer) of the commodity.

Here’s an example

An example might be a farmer who is planting corn. There might be 100 days between planting the corn and eventually having it harvested and ready for delivery, and during these 100 days, anything could happen to the price of corn.

The farmer has price risk, if the price of corn plummets then the farmer may end up losing money by the time the corn has grown and they are ready to sell it.

To remove this price risk, the farmer hedges their price risk by selling futures that are trading as close to 100 days in the future, when they are ready to make delivery.

The farmer has now locked in the price today, to deliver the corn 100 days in the future.

It’s estimated that less than 7% of traded futures contracts are traded by actual hedgers (producers and consumers). The remaining volume is traded by speculators.

The function of traders

The vast majority of trading in futures contracts at an Exchange is done by traders, and these traders have no intention of taking or making delivery of the underlying commodity.

They speculate on the price direction of the commodity, make a trade, and close out the position for a profit or loss. 

These traders play a very important role in the functioning of markets. 

By taking the other side of the trade from the hedger, the trader takes on the price risk. This is known as providing liquidity, and with so many traders participating on a daily basis, a fair price is established (this is known as 'price discovery').

So traders create an efficient price discovery marketplace, with liquidity, and this allows hedgers to be able to hedge their price risk in a clear, fair, and transparent way.