What are “Futures Contracts”?

Future contracts, also known as futures, are standardized legally binding agreements between a buyer and seller to receive (known as taking a “long” position) or deliver (known as taking a “short” position) a commodity or financial instrument sometime in the future, at a price that has been agreed upon today. These contracts are identified according to the previously agreed maturity date an example can be, an August 2008 Wheat futures contract or a June 2008 S&P 500 stock index futures contract.

Futures are often traded in open-outcry and auction-style trading pits, at designated stock exchanges. Electronic trading systems like, Chicago Mercantile Exchange’s (Globex System are also used, in certain exchanges. Chicago Mercantile Exchange was the first to introduce futures trading. The exchange clearinghouse guarantees the performance and counterparty risk elimination, by substituting itself as the buyer to the seller and as seller to the buyer. The futures trade customers are required to post margin deposits, not against the market value of the commodity in the futures contract but as a performance bond or “good-faith deposit”, with an exchange member firm which, in turn, must deposit margin with the exchange, which ensures the market participants’ ability to honor their financial commitments and cover any obligations which might arise out of their trading activities.

A “long” position is the one in which we buy, i.e. receive a futures contract, and selling, i.e., delivering a futures contract is referred to as taking a “short” position. A long futures position profits when the futures price goes up, and a short futures position profits when the futures price goes down. Maturing futures contracts expire on specific dates, usually during the contract month. The futures trader may also offset or exit his obligation at any time before the contract matures, by selling what was previously bought, or buying what was previously sold. This way, a trader is relieved of any obligation to make or take delivery of the underlying commodity or financial instrument.

Futures contracts have standardized terms and trade on centralized exchanges. Its participants in futures trading can be divided into two broad categories: Hedgers, who actually deal in the underlying commodity or financial instrument and seek to protect themselves against adverse price fluctuations, and Speculators, who seek to profit from price swings.

The vast majority of futures contracts, in fact, are closed out by offsetting market transactions prior to their maturity, rather than through the delivery process.

Futures trading also carry significant risk, since; the futures contracts generally entail high levels of leverage. Due to this they have been at the heart of many market blowups. The most famous of all may well be Long Term Capital Management (LTCM); despite of having the best financial brains on their payroll, LTCM managed to lose so much money so rapidly that the Federal Reserve Bank of the United States was forced to intervene and arrange a bailout to prevent a meltdown of the entire financial system. Enron, Nick Leeson and Barings Bank have also faced the brunt of “futures” mismanagement.

In the United States, futures transactions are regulated by the Commodity Futures Trading Commission.

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