How Futures Trading Works?

The future market is exactly like any other market, where buyers and sellers converge together. The only difference is that they deal in futures contracts. The pricing of such contracts are carried out by placing bids and offers. The futures contract will state the price that will be paid on the future date of delivery. But almost all futures contract end without the delivery of the physical commodity.

So, what is a Future Contract?

In simpler terms, in a futures contract you make an agreement to receive a product at a future date with the price and the date of the delivery already set at the time of the contract. You secure your price even if the price rises when the date of delivery is near. With a futures contract you reduce your risk of paying higher prices completely.

For example a wheat producer might be trying to secure a selling price for the next season’s output or a bread maker is trying to secure a buying price to determine how much bread can be made from the wheat and at what profit. So the farmer and the bread-maker will enter into a futures contract in order to buy and sell the product at hand. It is a short position for the wheat farmer and a long position for the bread-maker.

In every single futures contract, everything is normally specified. From the quantity and quality of the produce to the specific price per unit as well as the date and method of the delivery. The price of the futures contract remains the same even at the time of delivery.

Gains & Losses

Moving on to the most important part of any business transaction- profit and loss. The daily movement of the market will determine the profit and loss of any futures contract. If there is an increase in the price of the commodity that is part of a futures contract after the agreement has been made, the seller loses while the buyer profits. On the other hand if there is a decrease in the price of the commodity after the contract has been established, the buyer suffers a loss while the seller profits from the transaction. Whenever the change occurs the buyer and the seller’s account get credited and debited accordingly. These changes are made on a daily basis unlike ordinary stocks of the stock market when the transaction happens only when the stocks are actually sold or bought.

Due to the nature of adjustment on a daily basis, all futures market transactions are settled in cash and the actual physical commodity is bought and sold in the cash market. Hence prices in the cash market and the futures market tend to run in parallel so that when the contract expires, the prices merge into each other.

The futures contract is a financial position and in reality you do not need to go to the cash market to buy or sell the commodity at all after the expiration of the contract.

Economic Significance of the Futures Market

The futures market act as a good source of market information. Due to its highly competitive nature, the futures market is a brilliant tool to determine prices based on supply and demand. The prices depend on a continuous flow of information around the world and factors such as weather, war, debt, etc. affect the prices through the forces of supply and demand. The market also becomes a place where people reduce their risk when they are making purchases. Since the prices are set from the start, participants know how much to buy or sell from the beginning.