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A future is a contract: an obligation to buy or sell a specific quantity of a certain commodity or asset on a future date at an agreed upon price. Futures contracts are nothing new, with trading of them starting at the Chicago Board of Trade (CBOT) in 1865. (The CBOT became part of the CME Group in 2007 to form the world’s largest exchange.) The contracts represent commodities you know and hear about in the news every day, including oil, corn, gold, and financial instruments you may have already traded (like the S&P 500). What is Futures Trading? Because the terms of futures contracts for each commodity or asset are standardized (i.e., same quantity, quality, delivery), they can be traded on an exchange. The only variable is the price of the futures contract. This means you can buy or sell barrels of oil or bushels of corn or bars of gold. You do not need to take delivery of the commodity today—it’s a “future” contract—so you do not need to rent storage tanks or bank vaults to profit from price movement. As a stock trader, you know this differs from stocks in that stocks represent actual ownership of a corporation. The “$value” of that ownership depends on the quality of the product being sold, the talent of the management team in place, the competition, etc. The $value of a crude oil futures contract, for example, depends on what people believe the price of oil will be on the date the contract expires. If you believe the future price of oil will be higher, then you would buy the contract. If you believe the future price will be lower, then you sell the contract. Selling a futures contract is similar to shorting stock in the equities market: You believe the price will go down, so you sell. Only with futures, you do not have to borrow stock to short it (and pay a stock loan fee). Unlike stocks with their fixed number of shares available for trading, there is no limit to the number of futures contracts outstanding in a particular commodity. As long as the market has a matching buyer and seller (i.e., they agree on the price), another contract will be created. The futures exchanges clearing corporations handle this automatically (you do nothing) and are regulated by the Commodity Futures Trading Committee (the futures industry version of the SEC) and the National Futures Association (NFA). Warning: Futures contracts expire. And this is one of the bigger, if not the biggest, differences between stocks and futures. On the expiration date, futures contracts may call for physical delivery of the commodity, while others are settled in cash. To close out a position in a futures contract, and avoid delivery, you “offset” the contract. This means if you were long a futures contract (i.e., having bought a contract), you would sell a matching contract. If you were short a futures contract (i.e., having initially sold a contract), you would buy a matching contract. Either of these actions exits your position, just as selling a stock in the equity markets would close a position.The actual delivery rate of the underlying goods specified in futures contracts is very low, because hedging or speculating benefits can be had without actual delivery of the goods. Who Uses Futures and Why?Participants in the futures market are typically described as either Hedgers or SpeculatorsHedgers. Hedgers make purchases and sales to establish a known price level for something they intend to buy or sell in the cash market at a future date. Farmers, food processors and energy producers are examples of hedgers who lock in prices using futures contracts to protect against price volatility. Hedging becomes a form of price insurance.
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