Futures Contract

A futures contract is a legal agreement between two parties for the sale and purchase of a physical commodity or financial instrument at a future date. Because its value depends on the price of the asset it involves, a futures contract is classified as a derivative product. Futures contracts were originally developed to provide producers and manufacturers the opportunity to mitigate the financial risks associated with price fluctuations of the agricultural commodities with which they dealt, but the modern futures market also allows speculators to trade futures contracts as an investment activity.

Futures contracts are traded on futures exchanges, and the trading activity is typically coordinated through clearing houses, which act as intermediaries between buyers and sellers. The contracts outline the specifics of the underlying transaction; they define the commodity or instrument involved, the details of delivery and the predetermined price or rate. Certain aspects of a futures contract (the quality and quantity of the asset and the date, method and location of its delivery) are standardized to enable trading across futures exchanges. In addition, each contract includes both a long (the buyer) and short (the seller) position. The commodity’s price per unit, on the other hand, is variable.

While some participants in the futures market (farmers and food processors, for example) use futures contracts to lock in prices on commodities they will actually buy or sell, most contracts are settled in cash. This contract settlement without delivery often occurs through a process called offsetting, in which futures contract holders “reverse” the trade with a subsequent counter transaction that closes their position in the contract, thereby eliminating their obligation to make or take delivery of an asset.

As a result, price fluctuations in the futures market generally correspond with the actual values of commodities in the cash market. This activity gives investors, as well as those who eventually buy or sell the underlying commodities on the cash market, the opportunity to profit by hedging or speculating on the future prices of various assets by buying and selling futures contracts.