What is a Futures Contract?

You may have heard of an investment option called a futures contract. Futures contracts are not anything new; they originated in agriculture as a way to hedge against bad harvests and profit in the event of good harvests.

Now, you can have futures contracts on a wide variety of assets beyond agriculture – to include stocks, stock markets, bonds, currencies, and other instruments. Here, we’ll talk about futures and go over a futures contract example to give you a good idea of how these assets perform and how you can take advantage.

The Basics: What is a Future?

Pretend you’re a farmer growing, say, corn. Due to how unpredictable growing crops can be, thanks to changing weather and other factors, you’re not exactly sure how much you can sell your corn for this fall. So, you arrange for your goods to be sold today at a certain price, then delivered in the future – the fall – when the corn is actually harvested. This way, you have money in your pocket regardless of what happens in the fall.

Of course, you want the price to fall between now and then, since that would represent a better-than-expected return on your investment. Similarly, those who buy the contracts want the price to increase, since they’ll obtain, say, corn at $50 a bushel while only paying $40 a bushel in advance.

A futures contract is just like what happened in the above scenario. One party agrees to take delivery of a certain asset at a certain time in the future for a certain price. This is similar to an option, but unlike an option, a futures contract represents an obligation – whereas an option only represents the right to take action.

Types of Futures

There are several types of futures on the market today, far beyond their traditional use in agriculture. You can buy futures for a wide variety of commodities, from corn and wheat and cotton to gold, silver, platinum, and copper. You can also buy futures for stocks, stock indices, and other instruments.

The above represents two types of futures: physical delivery and cash settlement. This refers to how the contracts are settled at expiry. Those who buy, say, corn futures actually take physical delivery of corn. Only about 2% of commodity contracts are actually delivered physically, though; most of the time, traders exit their positions and take profits (or losses). Cash settlement is also a possibility; most financial instruments are cash settled, as are hogs and cattle.

When you look up a futures contract, check for its delivery method. Your broker will alert you when the physical delivery date draws near and give you the chance to settle your contract.

Making a Profit off Futures

So, how do you make money with futures?

Let’s use an example from the markets. Let’s say you want to trade oil, or specifically, light sweet crude. You’re looking for a contract that expires in December, 2012. Right now (September 8, 2012) you can purchase barrels of oil for that delivery date for $96.87 per barrel.

You want the price of oil to rise so that when the expiry date nears, you can settle your contract and turn a profit. Let’s say that the price of oil, at expiry, is $97.87. You would turn a profit of $1.00 per barrel, and the person who sold you the contract would essentially lose $1.00 per barrel.

It sounds simple, and to a degree, it is – but it does get complicated.

There are two conditions you want to keep an eye on when trading futures contracts: contango and backwardation.

Contango and Backwardation

We’ll touch on contango first. An asset – be it corn, oil, pork, or stocks – is said to be in contango if the current price of a contract is above the expected price at maturity, or the spot price. If you were to plot this, you would see a line that is sloping downwards. Normally, the line slopes upwards.

Contango represents a potential trap for investors who are buying contracts. If the current price of oil with a December delivery date is $96.87, as discussed above, oil would be in contango if the expected spot price was, say, $93.87. That would represent a loss of $3 per barrel if the trend continued.

Backwardation is the opposite of contango. This is when the current price for a futures contract is trading below the expected spot price at maturity. If you were to graph this, it would resemble a normal upward slope.

If a market is in backwardation, the price will appreciate over time. Profiting, then, would entail buying a futures contract at the lower current price and settling for cash (or taking delivery) with a higher price at maturity.

Of course, it all isn’t as cut and dried as the above. These are expected prices we’re looking at – and spot prices at maturity can be unpredictable. It is possible to buy in market that is in contango and actually profit if the spot price is significantly higher. Oil, for example, was in contango for years before moving into backwardation in 2011.

Plus, you don’t necessarily lose money in contango (just like you don’t always make money in backwardation). You can be short in contango and profit as price decreases.

Getting Started in Futures

It’s recommended that you try to trade futures with a practice account before you go into real-time trading. Also, pick one commodity or asset and try to learn as much as you can about it. Each asset as certain pricing factors that come into play, be they weather, geography, economic factors, and even politics.

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