When most people think of futures trading, two things come to mind: extraordinary financial risk and very rich people. Those two things often go hand in hand, but nowhere is that the case more so than in this type of investment. Futures are contracts for the delivery of specified amounts of a certain commodity on a certain date in the future. Many of the commodities that are traded are agricultural, such as wheat, pork bellies, and orange juice concentrate. Futures contracts for many other “commodities” such as precious metals, currencies, and even interest rates, are also traded and exchanged.
Futures trading is unlike many other forms of investing, because a trader is not required to own or even buy the commodity. All that is necessary is to make a speculation on where the price of a particular commodity is going, and make a decision based on that. If an investor were speculating on crude oil, for instance, and he or she expected the price to go up in the future, that investor would buy crude oil futures contracts. An investor who expected that the price would be going down would sell crude oil futures.
The great majority of contracts are traded by speculators, who liquidate their position before the contract expires, taking either a profit or a loss from the transaction. In other words, the delivery of the commodity is not then the responsibility of the investor. The speculator does, however, play an important role in the economy. Most of all, they make it easier for those who actually need to deliver or take delivery of commodities to plan for the future.
For example, a wheat farmer may want to guarantee the price he will get for the wheat he has growing but has not yet harvested. To secure his price, he can sell a futures contract equal to the amount of wheat he expects to harvest. A manufacturer, such as a bread company, may buy the contract, also guaranteeing the price it will pay when the contract comes due. This avoids unpleasant surprises for both parties that would possibly occur if they had no other option than to buy and sell and the current market price when it came time for them to do business. Most likely, the two parties won’t need to buy and sell at the same time, though, and this is where the role of the speculator is so important. Their involvement in futures trading means there is always someone to buy the contracts being sold, or to sell the ones being purchased.