A futures contract is a standardized contract that calls for the delivery of a specific quantity of a specific product at some time in the future at a predetermined price. Futures contracts are derivative instruments very similar to forward contracts but they differ in some aspects.
Futures contracts are traded in futures exchanges worldwide and covers a wide range of commodities such as agriculture produce, livestock, energy, metals and financial products such as market indices, interest rates and currencies.
The primary purpose of the futures market is to allow those who wish to manage price risk (the hedgers) to transfer that risk to those who are willing to take that risk (the speculators) in return for an opportunity to profit.
Producers and manufacturers can make use of the futures market to hedge the price risk of commodities that they need to purchase or sell in order to protect their profit margins. Businesses employ a long hedge to lock in the price of a raw material that they wish to purchase some time in the future. To lock in a selling price for a product to be sold in the future, a short hedge is used.
Speculators assume the price risk that hedgers try to avoid in return for a possibility of profits. They have no commercial interest in the underlying commodities and are motivated purely by the potential for profits. Although this makes them appear to be mere gamblers, speculators do play an important role in the futures market. Without speculators bridging the gap between buyers and sellers with a commercial interest, the market will be less fluid, less efficient and more volatile.
Futures speculators take up a long futures position when they believe that the price of the underlying will rise. They take up a short futures position when they believe that the price of the underlying will fall.
In March, a speculator bullish on soybeans purchased one May Soybeans futures at $9.60 per bushel. Each Soybeans futures contract represents 5000 bushels and requires an initial margin of $3500. To open the futures position, $3500 is debited from his trading account and held by the exchange clearinghouse.
Come May, the price of soybeans has gone up to $10 per bushel. Since the price has gone up by $0.40 per bushel, the speculator can exit his futures position with a profit of $0.40 x 5000 bushels = $2000.
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