A farmer planting a 10,000-bushel soybean crop in Chana, Illinois, might want to sell part of it now to ensure a certain price upon harvest. Similarly, a food-processing company might want to purchase soybeans now to protect against future price increases. An orange juice manufacturer might want to lock in a supply of oranges at a definite price now to avoid the risk of a winter freeze pushing up prices. These economic needs create futures markets.
The concept of a forward market is based on participants facilitating the purchase and sale of products that will not be produced or available until a specific time in the future.
Any futures market is based on some underlying product, often a physical commodity, offering producers or end-users the ability to hedge against adverse price movements in the value of the end product.
Agree to buy the asset in the future.
Agree to sell the asset in the future.
Can be physical delivery or cash settlement.
Sellers of these products may wish to lock in as high a price as possible to ensure they make at least a profit or, at worst, cover production costs. End-users may wish to hedge against rising prices to ensure a reasonable price for any commodity and control their costs.
The more producers, buyers, sellers, and hedgers that interact in any futures market, the more speculators are drawn in, creating additional liquidity and generally improving market conditions.
A speculative investor who buys or sells a commodity contract hopes that the market price of the commodity will rise (or fall) before the contract matures, usually 3 to 18 months after it is written. Futures offer the potential for high profits because all futures contracts are highly leveraged. Depending on the commodity, market volatility, and brokerage house requirements, an investor can put up as little as 5 to 15 percent of the total contract value. Some contracts require a deposit of only $300. Commissions are very low, usually less than $5 per contract.
Whether you’re a speculator willing to assume risk for profit or an investor adopting a hedging strategy to protect a position, futures allow you to lock into prevailing prices.
The forward or future price must account for multiple factors that can influence the product’s price. The structure of the end product, whether physical or purely financial, must be clearly specified in the contract. Over many decades, exchange-traded futures contracts have grown into popular investment vehicles.