When you think of investing, you might imagine buying relatively straightforward securities like stocks and bonds. But the futures market also offers investors the opportunity to make some money. A futures contract is a binding agreement between two parties wherein they agree to buy or sell certain assets or commodities at a specified time in the future.
How futures contracts work
Futures contracts are a type of derivative, which is a security whose price is derived from one or more underlying assets. Futures contracts can be bought and sold on any futures exchange, such as the New York Mercantile Exchange or the Chicago Mercantile Exchange. Under a futures contract, a buyer will agree to purchase a certain quantity of a commodity or asset at a predetermined price. The seller, meanwhile, will agree to sell that quantity at the agreed-upon price. The contract will also include the future date at which the sale will take place.
Futures contracts were originally associated with commodities such as oils, grains, seeds, and metals. Farmers, miners, and other such providers of commodities needed a way to manage the financial risk of having to produce their goods in the future, and locking in prices up front helped them achieve this goal. Similarly, those on the buying end were protected from significant price fluctuations by locking in prices ahead of time.
These days, the futures market encompasses more than just commodities. Today, futures contracts are traded based on assets like stock market indexes, foreign currencies, and Treasury bonds. While futures contracts may call for the physical delivery of the asset or commodity in question, most are settled in cash.
In every futures contract, there's one party who holds a short position and one who holds a long position. The party who holds the short position agrees to deliver a commodity, while the party who holds the long position agrees to receive that commodity. Another way to think of it is that the seller holds the short position, while the buyer holds the long position.
Earning and losing money from futures contracts
The profits and losses of a futures contract depend upon daily movements of the market. Let's say a futures contract calls for Party A to purchase 100 bushels of wheat at $5 per bushel from Party B at a date in the future. If the price of a bushel of wheat increases to $6 per bushel the following day, Party B (the seller) has lost $100 ($1 per bushel) that day because the going price has increased from the future price at which he is obligated to sell. Meanwhile, Party A (the buyer), has profited $100 that day because the future price he's locked into is less than the current price.
Unlike stock positions, where gains and losses aren't realized until shares are actually sold, futures positions are settled on a daily basis, which means that gains and losses are calculated each day and added to or subtracted from a contract holder's account. Though investing in futures contracts can be profitable, it can also be risky. That's why those who are new to investing don't typically dive into futures right away, but rather stick to investments like stocks and bonds that are far less complex.
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