101-11 Futures Markets – How to they work?

This section provides an overview of the futures markets and trading stock options.  It will give you a good understanding of why the markets exist and how people seek to profit from them.

The Futures Markets

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Futures contracts are traded on the futures markets.  They differ markedly from other contracts or financial transactions.

Using futures is a common way of hedging your bets or, indeed, securing a given asset at today’s price for an agreed future delivery date.

For example, the sugar cane farmer may require some investment in new machinery for next year’s harvest.  He could enter into a futures contract by selling 100,000 pounds of sugar for 21 cents per pound; he would receive the money and fix the price for the future date.  The other side of this trade might be a chocolate manufacturer.  The chocolate manufacturer sees that sugar prices are rising rapidly and decides that this will negatively affect his profit margins, so he enters into the agreement for delivery of the sugar in 2 years’ time at today’s price.

This enables the chocolate company to hedge the risk of rising prices, but also allows the farmer to invest in the machinery to deliver the product.

It could also work the other way.  The farmer might see that sugar is at an all-time high and decide to sell futures contracts at this price to ensure that he received this higher amount in the future, thus protecting himself from any downside swings in the price of sugar.

One crucial point, a futures contract usually does not mean you need to take delivery of the goods on the delivery date.  Mostly this just means the contract terminates, and you receive the cash equivalent.  Then the money you have gained from the futures transaction you can then use to go the spot market and purchase the sugar you need.

A futures contract, whether for commodities, currencies, or even based on the movement of a stock or index, is simply a financial derivative based on the value of the underlying assets.