What Futures Contracts Are

Futures contracts are promises; the person who initially sells the contract promises to deliver a quantity of a standardized commodity to a designated delivery point during a certain month, called the delivery month. The other party to the trade promises to pay a predetermined price for the goods upon delivery. The person who promises to buy is said to be long; the person who promises to deliver is short.’

There are some analogies between a futures contract and an option contract. Both involve a predetermined price and contract duration. An option, however, is precisely that: an option. The person holding an option has the right but hot the obligation to exercise the put or the call. If an option has no value at its expiration, the option holder will allow it to expire unexercised. But with futures contracts, a trade must occur if someone holds the contract until its delivery deadline. Futures contracts do not expire unexercised. One party has promised to deliver a commodity that another party has promised to buy.²

For instance, a trader may purchase a July soybean contract at the Chicago Board of Trade. The purchase price might be $6.22 per bushel. This contract calls for the delivery of 5,000 bushels of No. 2 yellow soybeans to a specially designated regular warehouse at an approved delivery point by the last business day in July. Upon delivery, the purchaser of the contract must pay $6.22 for each of the 5,000 bushels, or a total of $31,100. If the current price (spot price, or cash price) for soybeans is higher than $6.22, the purchaser of the contract will make a profit. A spot price of $6.33 would result in a profit of $0.11 on each of 5,000 bushels, or $550. In contrast, if the spot price were only $6.15, the buyer would lose $0.07 per bushel, or $350.

An important concept to keep in mind with futures is that the purpose of the contracts is not to provide a means for the transfer of goods. Stated another way, people cannot transfer property rights to real or financial assets with futures contracts. Futures contracts do, however, enable people to reduce some of the risks they assume in their business.

Most futures contracts are eliminated before the delivery month. Similarly, people who buy puts or calls do not usually intend to exercise them; valuable options are sold before expiration day. An individual speculator who is long a corn futures contract does not want to take delivery of 5,000 bushels of the commodity. A farmer who has promised to deliver wheat through the futures market may prefer to sell the crop locally rather than deliver it to an approved delivery point. In either case, the contract obligation can be satisfied by making an offsetting trade, or trading out of the contract. The speculator with a long position would sell a contract, which would cancel the long position. The farmer with a short position would buy. Both individuals would be out of the market after these trades.

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Futures Contracts

• Why We Have Futures Contracts
• Foreign Currency Futures
• Principles of Futures Contract Pricing (T1)
• Option to choose the delivery day: the timing option
• The Origins of the Futures Industry (part 1)
• Pricing futures on interbank interest rates
• Embedded options and the fair price of a future
• The Origins of the Futures Industry (part 2)
• Forward interest rates and expectations
• The Origins of the Futures Industry (part 3)