What Are Futures? – Futures Trading Explained
Future Trading Terms Explained
The following terms are necessary to explain what futures trading means:
- Commodities are the items traded in a futures trading exchange. The following are some commodities actually traded (1) wheat, (2) corn, (3) gold, (4) currency, (5) light sweet crude oil, and (6) interest rates.
- Exchanges are the organizations listing prices of commodities and settling contracts for futures trades. One of the major exchanges is the Chicago Board of Trade (CBOT). Exchanges are not limited to the U.S. There are exchanges all over the world that deal in commodities.
- Hedgers are persons who trade because they have an actual interest in the commodity, whether to sell it or buy it.
- Speculators are persons who usually have no actual interest in the commodity but do have an idea where the market for a commodity will end up in the future.
- Margins are the amount of money needed on deposit to trade in a commodity and will fluctuate as the commodity goes up or down.
- Futures contracts are contracts listing the amount of the special type of commodity being bought or sold, the price at which it is set, and the delivery point and date.
What Are Futures?
If a farmer has planted a corn crop that is estimated to produce 100 bushels per acre and the field is 100 acres, the farmer will have 10,000 bushels of corn to sell when harvest time comes. After computing the price needed, the farmer may seal that price by commissioning a broker to sell a futures contract for 10,000 bushels of corn to be delivered in November at that price. The farmer then becomes a hedger and must delivery 10,000 bushels of corn to market by the end of November unless the contract is terminated.
This contract is only valid if another person either thinks the price of corn will go up or the person needs 10,000 bushels of corn. An ethanol plant may be interested in purchasing this contract. If so, both parties are hedgers. A person not interested in getting 10,000 bushels of corn, but one who does think the price of corn will go up by November may buy the contract. That person is trading futures as a speculator.
The commodity does not actually change hands, nor does the total price change hands on the date the futures trade is made. Based on the price of the contract, only a margin or percentage of that price is required. Let us consider that the farmer is the seller and the ethanol firm is the buyer. If the farmer sells the 10,000 bushels of corn for $3.50 per bushel, the contract is worth $35,000 at the point of sale. If the margin required to seal this contract is five percent, the farmer must place $1,750 in a margin account. The ethanol firm must also place that amount of margin in an account. Now, if the price of corn goes to $3.60 per bushel, the buyer is into profit by $50. That amount is transferred from the farmer’s margin account into the ethanol firm’s account. Conversely, if the price of corn drops to $3.40 per bushel, the $50 is transferred from the ethanol firm’s margin account into the farmer’s margin account. This transfer takes place daily. Margin calls for more money are needed when the account goes below a certain level.
If the contract goes to delivery date, the farmer delivers the corn and the ethanol firm picks it up. Most futures contracts do not go to the delivery date.