Over $2 trillion are traded on futures exchanges every year. Still, futures are much less well known than stocks and bonds. Even if you only trade in stocks and bonds, understanding futures gives a deeper view of the whole financial system.

Standardized Contracts

Futures are standardized contracts to buy or sell a commodity at a set price on a fixed future date. Being standardized means that the quantity and quality are specified along with price and date. For example, the standard Chicago Board Of Trade contract for corn futures specifies 5,000 bushels of number 2 Yellow corn to be delivered at a port on the Illinois River at the end of a specific month.

Commodities

A commodity is any standardized good, service, or financial right or interest when a contract is written to deliver it at a future date. It could be number 2 Yellow corn, shares of stock in a company, Japanese Yen, oil, or government savings bonds. A unique work of art could not be a commodity because it could not be standardized.

For Future Delivery

Futures are called futures because they set a fixed date in the future when a commodity must be delivered. Only about 1 percent of futures contracts actually result in physical delivery. Most contracts are closed by matching up a contract to buy with a contract to sell or by the buyer and seller settling for the cash difference between the futures contract price and the market price of the commodity on the day of delivery.

Traded On An Exchange

Exchanges are organized to standardize contracts and make sure futures are traded fairly and contracts are paid. You can trade futures through a broker on an exchange. Try out trading at the Chicago Mercantile Exchange simulated trading game.

Hedging

The original use for futures contracts was hedging, or reducing risk by setting a price ahead of time for commodities that someone was going to produce or buy. A farmer might want to set a price for a wheat crop to secure a bank loan and a baker might need to know how much flour would cost to plan an expansion on his bakery. They could each buy one end of the contract, with the farmer selling and the baker buying.

Financials

Today the majority of futures are financial futures. Bond futures began trading in 1975 and stock futures in 1982 but they have overtaken agriculture, metals, foreign currencies, and energy futures in volume. Traders can take positions on individual stock prices, indexes, and interest rates. Of course, financial futures representing the prices of paper securities never present the danger that a trader might end up with 5,000 bushels of number 2 yellow corn if the contracts aren't closed by the delivery date.

Source:

"Understanding Futures Markets;" Kolb Robert W. and Overdahl, James A.; 2006

More Information:

The Chicago Mercantile Exchange: Getting Started and Simulated Trading