How Does The Futures Market Work?
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 delivery date (in the future).
The Seller of a Futures Contract
A Sugar Cane Farmer may require some investment in new machinery for next years 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 in which the sugar must be delivered.
The Buyer of a Futures Contract
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 enable 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 important point, a futures contract normally 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 this the money you have gained from the Futures transaction you can then go the Spot Market and purchase the sugar you need.
So a futures contract whether for commodities, currencies or even based on the movement of a stock or index, is simply a financial derivate based on the underlying asset’s value.