Futures

Futures and forward contracts are contracts between two parties to undertake a transaction at an agreed price on a specified future date.

Futures and forward contracts are contracts between two parties to undertake a transaction at an agreed price on a specified future date. In contrast to buying options, which give you the choice to walk away from the deal, with futures you are committed and are unable to back away. This is a very important difference. In purchasing an option the maximum you can lose is the premium paid, whereas you can lose multiples of the amount you employ in taking a futures position. The key difference is that the holder of an option to buy is not compelled to buy and will not do so if the trade is unprofitable. A futures or forward contract, however, carries the obligation to go through with the agreed-upon transaction.

A forward contract is simply a deferred-delivery sale of some asset with the sales price agreed on now. All that is required is that each party be willing to lock in the ultimate price to be paid or received for delivery of the commodity. A forward contract protects each party from future price fluctuations.

Futures contracts also differ from forward contracts in that they call for a daily settling up of any gains or losses on the contract. In the case of forward contracts, no money changes hands until the delivery date.

The futures contract calls for delivery of a underlying asset or commodity at a specified delivery or maturity date, in which the trader commits to make or take, called the futures price, to be paid at contract maturity. The contract specifies precise requirements for the commodity.

Because the futures exchange specifies all the terms of the contract, the traders need bargain only over the futures price. The trader taking the long position commits to purchasing the commodity on the delivery date. The trader who takes the short position commits to delivering the commodity at contract maturity. The trader in the long position is said to "buy" a contract; the short side trader "sells" a contract. The words buy and sell are figurative only, because a contract is not really bought or sold like a stock or bond; it is entered into by mutual agreement. At the time the contract is entered into, no money changes hands.