What is the Futures Market?
The futures market refers to organized exchanges where enforceable contracts for the future delivery of specified commodities at predetermined prices are purchased and sold. In a futures contract, a buyer and seller agree on the date for the delivery of the commodity, the price to be paid, and the quantity to be delivered. On the delivery date, the buyer is legally obligated to accept and the seller must deliver the specified commodity at the contractually predetermined price. Futures contracts are available for many commodities, including wheat, soybeans, precious metals, and oil, as well as for various financial instruments that are usually based on specific broad-based stock, currency, or interest rate indexes.
Merchants, manufacturers, and producers whose business requires the bulk purchase or sale of commodities use futures contracts to hedge their risk against price fluctuations of the underlying commodity in the future. For example, a grain merchant who purchases wheat for his inventory in the cash market for later delivery and resale may seek to ensure against a drop in the price by selling a like amount of wheat through the sale of a futures contract. Since prices in the futures and the cash, or "actuals," market are closely related, usually a gain or loss in the actuals market is offset by a commensurate decline or appreciation in the futures market.
Trading in commodities futures contracts is conducted worldwide on various exchanges including New York, London, Sydney, South Africa, and Chicago. The price of each futures contract is established on an exchange by a transparent bidding or auction system that matches open buy and sell orders for the specified contracts at any given time. As the price of the underlying commodity changes, the price of the futures contract itself rises or falls accordingly. Speculators seek to profit in the futures market by timing their transactions so as to exploit these price variations. By their willingness to assume risk in trading futures positions, speculators help provide liquidity to the futures markets.
Since those with commitments in the cash market employ transactions in futures as a vehicle to hedge against adverse price movements, very few futures contracts are ever settled for actual delivery of the underlying commodity. As such, transactions in the futures market differ markedly from those effected in both the stock market and commodities cash market in that transactions in futures rarely result in the actual transfer of any asset or commodity from seller to buyer. Most of the futures traded on the major exchanges are closed out prior to the contractual settlement or delivery date. In order to avoid making or accepting physical delivery of the specified commodity, a holder of a futures contract must close out his position prior to the expiration date of the futures contract. This can be accomplished by taking the opposite side, either buy or sell of the original opening transaction.
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