Futures

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A futures contract may be described as a contract in which both the buyer and the seller agree to the exchange of an underlying instrument (a type of asset) on a certain day and at a certain time. This date is known as the final settlement date or the delivery date.

There are a few different types of contracts that are available to investors. One is an options contract, which gives the holder the right to buy or sell. However, futures contacts are obligatory contracts, which means that the holder must buy or sell on the final settlement date. The holder has agreed to this mandatory change of hands and must abide by the agreement stated in the contract.

There is, however, one way to exit the commitment before the settlement date. To do this, the holder must either buy back a short position or selling a long position.

Perhaps the most common instance where one would find future contracts at work would be in a business that deals largely with commodities. According to the article "Why Futures Markets are Important[1], understanding futures can be as simple as understanding how a farmer or a rancher does business. Substitute the two business firms for a farmer and a rancher. The farmer wants to sell his corn at next year's market, but he has no way of knowing what the price of corn will be by then. The rancher knows that he will need corn to feed his horses, cattle and other livestock, but he, too, has no way of knowing if the prices of corn next year will be too high for him to afford purchasing what he needs.

What the farmer and rancher would do if they entered into a future contract, would be for the farmer to sell 1,000 bushels of corn to the rancher at a set price. The rancher would agree to pay that set amount when the final settlement date arrived. This way, the buyer and seller both benefit from the agreement, and neither one has to worry about the fluctuation of prices over the coming year.

Business firms that deal with such commodities as oil and agricultural produce often enter into future contracts in order to prevent substantial losses caused by fluctuations in the market for the commodity they are purchasing.