What is a Futures Contract?
A futures contract is a standardized agreement to buy or sell an asset at a fixed price at a specified date in the future.
People use these contracts to trade the future value of a tradable asset in the present.
For example, a trader can purchase a contract that guarantees the right to purchase a barrel of crude oil one year in the future for $100 per barrel, even if the price has risen to $150 per barrel by then.
Futures contracts are most commonly used to trade commodities (e.g., crude oil, corn) and financial assets (e.g., stock market futures). These contracts trade on futures exchanges, which are run separately from stock and bond market exchanges.
How Futures Contracts are Priced
Futures contracts are priced based on a complex mathematical model that takes into account several factors including the current price of an asset, the level of interest rates, the length of a contract, expected dividends, and more.
Professional traders use these complex calculations to inform what they would be willing to pay for a contract; however, what matters most to traders is the expected future price of the asset.
If the price of an asset is expected to rise, traders should be willing lock in the current price, and the opposite is true if an asset’s price is expected to fall.
Futures Contracts: Hedgers and Speculators
A person who trades futures is either a hedger or a speculator.
Hedgers are exposed to the price fluctuations of a traded asset and seek to use futures to lock in a desired price. In other words, hedgers use futures contracts to manage risk.
For example, crude oil comprises a very large portion of an airline’s budget, and in some years the fluctuating price of oil can be the difference between the airline’s being profitable and losing money.
If the current price of crude oil is attractive, an airline may want to use futures contracts to guarantee the right to purchase oil at similar levels in the future.
Speculators use futures contracts to make a directional bet on the price of a traded asset.
For example, a trader who believes a lack of rain in the Midwest will result in a bad year to grow corn may want to use futures contracts to profit if the price of corn rises as a result of the weather.
The trader enters into a futures contract that gives them the right to buy corn at current price levels six months from now. If the price of corn doubles in six months, the trader's right to buy corn at half the market price will result in a significant profit.