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In the most general sense, futures are all about future prices. People who trade
futures essentially trade agreements about how much they will buy or sell
something for at a specific date in the future — usually the nearby future,
within a few months or less. These agreements are contracts that also specify
the quantity and other details of the commodity being traded. Trading is done on
a commodity exchange such as Chicago Merchantile Exchange (CME).
Futures contracts are traded through an auction-like
process, with all bids and offers on each contract made public. It seems as if people always get worried when they hear about commodity
futures, the last thing they want is 5000 bushels of corn or some other
commodity to store in their garage. You might be surprised to know that the
futures markets are rarely used to actually buy or sell the physical commodity
such as corn or financial instrument (S&P 500) being traded; they're used for
risk management, and for some people, investment and profit. Futures
are most often used by producers, consumers, and
speculators.
The futures market is a centralized marketplace for
buyers and sellers from around the world who meet and enter into futures
contracts. Pricing can be based on an open cry system, or bids and offers can be
matched electronically. The futures contract will state the price that will be
paid and the date of delivery. But don't worry, almost all futures contracts end
without the actual physical delivery of the commodity. The futures markets were
initially developed to help agricultural producers and consumers manage the
price risks they faced with harvesting, marketing and processing annual crops.
But today, futures are also essential to the financial markets, providing risk
management tools related to currencies, interest rates, and stock and commodity
indexes.
What Exactly Is a Futures Contract?
Let's say, for example, that you decide to subscribe to cable TV. As the buyer,
you enter into an agreement with the cable company to receive a specific number
of cable channels at a certain price every month for the next year. This
contract made with the cable company is similar to a futures contract, in that
you have agreed to receive a product at a future date, with the price and terms
for delivery already set. You have secured your price for now and the next
year--even if the price of cable rises during that time. By entering into this
agreement with the cable company, you have reduced your risk of higher prices.
That's how the futures market works. Except instead of a cable TV provider, a
producer of wheat may be trying to secure a selling price for next season's
crop, while a bread maker may be trying to secure a buying price to determine
how much bread can be made and at what profit. So the farmer and the bread maker
may enter into a futures contract requiring the delivery of 5,000 bushels of
grain to the buyer in June at a price of $4 per bushel. By entering into this
futures contract, the farmer and the bread maker secure a price that both
parties believe will be a fair price in June. It is this contract–-and not the
grain per se--that can then be bought and sold in the futures market.
So, a futures contract is an agreement between two parties: a short position,
the party who agrees to deliver a commodity, and a long position, the party who
agrees to receive a commodity. In the above scenario, the farmer would be the
holder of the short position (agreeing to sell) while the bread maker would be
the holder of the long (agreeing to buy). (We will talk more about the outlooks
of the long and short positions in the section on strategies, but for now it's
important to know that every contract involves both positions.)
In every futures contract, everything is specified: the quantity and quality of
the commodity, the specific price per unit, and the date and method of delivery.
The “price” of a futures contract is represented by the agreed-upon price of the
underlying commodity or financial instrument that will be delivered in the
future. For example, in the above scenario, the price of the contract is 5,000
bushels of grain at a price of $4 per bushel.
Difference Between Futures and Forwards:
Remember that
almost every futures contract is closed out before the expiration date.
So, how does farmers sell their commodities? The
answer to this is forward contracts. A forward contract is
a variation of a futures contract that is similar in the sense that it is an
agreement between two parties to buy or sell a commodity or asset at a specific
future time for an agreed upon price. The difference is forwards are usually
only between groups that are genuinely interested in the underlying commodity
such as a producer and a merchant or two financial institutions. The table below
shows some more differences between forwards and futures:
Futures Contract
Forward Contract
Contract Guarantee
Guaranteed by the clearinghouse of the exchange on which the
contracts are executed.
No such
clearinghouse exists for forward contracts, it depends on the
party's creditworthiness.
Cash Flows
Futures
contracts require daily payments of profits and losses.
Forward
contracts generally do not involve daily payments of accumulated
gain or loss
Contract Terms
All
terms except for the underlying price of the commodity are
standardized.
Forward
contracts are created on a customized basis, as long as both parties
agree to the terms.
Liquidity
Very
easy to enter or exit a position because contracts are traded on an
exchange.
It can
be often very difficult to exit out of a forward agreement because
of the customized terms.
Spend less than you earn! People who spend every penny
they make usually end up going broke.......
Take enough risk on the money you save! Playing safe by
putting your money under the mattress or in a savings account
will not make you wealthy..
Remember that.....Fully one-fifth of humanity, some 1.3 billion people,
struggles to survive on less than $1 per day. About 40% of
humanity survives on less than $2 per day. More than a billion
people around the world will go to bed hungry tonight. Life
expectancy in some 32 countries is less than 40 years. If you
have a few extra dollars in your pocket (you don't have to be a
millionaire to make a difference), please share some of your
financial good fortune with others who are in great need.
Think About It... Being in the 'now' brings a freedom, unlike living
in the past or in the future, which is a kind of imprisonment.
This isn't a kind of a denial where you pretend life doesn't have
problems. Life is full of problems, but most of those stresses
and failures are reliving old hurts or worrying about future
concerns. -- Carl Honore
When you 're diagnosed with cancer, you start to
bargain with God: "Let me get through this, and I'll take better
care of myself. I'll get my priorities in order. I'll learn to
live every day to the fullest." Isn't it sad that you have to get
sick before giving yourself permission to live life to the
fullest? -- Robert Schimmel
Look at Life in different & Positive ways
