Most ordinary investors focus on stocks, bonds, mutual funds, and exchange-traded funds in building their investment portfolios. However, there are other financial markets that play a key role in the overall economy, and although many investors never participate in them, futures markets are among the most important. Let's look at what futures are and why you need to pay attention to them.
What futures contracts are
The futures market has its origins in the commodities industry. Farmers, oil and gas producers, miners, and others whose business it is to produce commodities wanted a way to manage the risk of having to accept an uncertain price for their future production. Futures contracts were the answer, and they met the needs of many market participants.
How a futures contract works is actually fairly simple. Under a futures contract, the contract seller agrees to sell a fixed amount of a certain commodity to the contract buyer on a particular day in the future. Most importantly, the price that the buyer will pay the seller is set based on the prevailing futures market price at the time the two parties enter into the contract.
Why people use futures
Futures have a useful function in managing risk. Take an example of a farmer who wants to sell this season's wheat crop to a bakery company. If the spot price of wheat falls between now and the time the farmer harvests the wheat, then without a futures contract, the farmer would take a financial hit. The futures contract provides the farmer with predictable compensation for the crop.
Conversely, the contract buyer also gets risk protection. If the spot price of wheat were to rise between now and when the bakery company needs it for its future needs, then the bakery would face an unexpected rise in expenses. Having the futures contract fixes the bakery's ingredient costs.
Of course, the downside of futures contracts is that you miss out on potential windfalls if the market moves in your favor. In the examples above, having a futures contract would cause the farmer to miss out on higher profits if wheat prices rose, or it would leave the bakery paying more than necessary for wheat if prices fell.
The breadth of the futures market
Now, futures go well beyond commodities. You can trade futures contracts based on non-physical benchmarks like stock market indexes, or you can trade financial assets like long-term Treasury bonds or foreign currencies. What these all have in common is that they allow you to predict trends well into the future, or lock in your future expectations now regardless of what actually ends up happening.
The futures market has a reputation as being risky. But understanding how futures work is important even if you never actually participate in the futures market itself, because futures have an impact on the companies whose shares millions of investors own.
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