Imagine a contract of some asset delivery by the seller to buyer on some specified date in future. Although the price is defined in such the contract, assets are not paid for before the delivery date. A buyer and seller have to deposit a definite some of money at the moment of the contract signing. The aim of this deposit is to protect any person from losses in case the other party of the contract refuses to complete the contract. So, deposit size is revised every day to provide enough safety. If it is too big, the excessive part may be called in.
These contracts are called futures contracts, or just futures.
- In the USA futures contracts are completed for the following assets:
- Agricultural commodities (wheat, corn, soybeans etc.);
- Natural resources (gold, copper, crude oil, natural gas etc.);
- Foreign currency
- Securities with fixed income (treasury bonds etc.);
- Stock indices (S&P 500, Nasdaq etc.).
These contracts can be made quite easily due to their standard terms and then any person may trade them.
Hedgers and speculators
Two types of people deal with futures — speculators and hedgers.Speculators buy and sell futures with the only aim — to take profit by closing their positions at the better price against the initial one. Speculators don't produce and use basic assets within the framework of common business. Hedgers, vice-versa, buy and sell futures to avoid any risky position on spot market. In the course of common business they produce or use the basic asset.
Example of hedging. Let's consider futures on wheat. The farmer notes that the market price for the futures on wheat with the delivery at harvest time makes today $4 per bushel. It is quite enough to take profit within the year. The farmer can sell the futures on wheat today, or he can wait and sell grain at harvest time on the spot market. However delay to the harvest bears some risks, as till this time the wheat price may decrease to $3 per bushel, which may cause the financial crash for the farmer. Selling of the futures today allows to fix the selling price at the level of $4 per bushel. Such the behavior of the farmer protects his main business from any risks. The farmer who sells futures is called hedger, or precisely «short» hedger.
Perhaps a baker who uses wheat to bake bread is the buyer of the farmer's futures. The baker has some stores of wheat till the harvest. On one hand, the baker can buy the futures today at the price of 4$ per bushel in order to restock his stores till the harvest. On the other hand, he can wait till his stores reduce and buy wheat on the spot market. However, the spot price may increase to 5$ per bushel. In this case the baker will have to raise the selling price for bread and as a result have losses from the sales volume fall. So, the baker can fix the selling price at $4 per bushel and as a result avoid any risks. The baker who buys the futures is also called hedger, or precisely «long» hedger.
Example of speculation. The farmer and baker may be compared with the speculator who buys and sells futures on wheat being guided by the price forecast for it. He has the aim to take profit within short period of time. As it was noted above, this person doesn't produce and use basic assets within the framework of common business.
If a speculator thinks that the wheat price will rise considerably, he will buy the futures. Later he will make a reversing trade. If his forecast is exact, he will take profit from the futures price increase. As an example let's consider a speculator who waits for the rise of the spot price for wheat, at least by $1 per bushel. In spite of the fact that he can buy wheat and keep it hoping to sell later at a higher price, it is easier and more profitable for him to buy the futures today at the price of $4 per bushel. After that, if to suppose that the wheat price rises by 1$, a speculator will make a reversing trade, having sold the futures at $5 per bushel. (The spot price rise by 1$ will cause the futures price rise also by about 1$.) As a result the speculator will take profit of about 1$ per bushel, or $5000 in total, as the futures includes 5000 bushels. The speculator will have to deposit $675 at the moment of buying. The money will return at the moment of reversing trade. So, the speculator has quite a high yield (740) against the percent of the wheat price rise (25). If the speculator forecasts a considerable fall of the price, he will sell the futures on wheat at first. Later he will make the reversing trade. In case of exact forecast, he will take profit from the futures price fall.
