What are futures contracts?
A futures contract acts as a standardised, legal document that refers to the delivery of a specified quantity and quality of a commodity at a predetermined date and with the price agreed in advance. The value of the contract is negotiated at a futures exchange, which acts as an intermediary between the two parties, and is based on the value of the physical item.
Futures contracts can be used by market participants physically involved in the supply chain (such as producers and manufacturers) looking to reduce their risk and exposure to market volatility; a process referred to as ‘hedging’. Hedgers can use the futures market to lock in a price for the product, giving them price certainty for the future. Producers looking to sell can hedge to minimise the risk associated with a price decline while a buyer can minimise the risk associated with a price increase.
Speculators also trade on the futures markets for profit. In comparison to hedgers, speculators seek to take advantage of the price risk that hedgers try to avoid. The motive of speculators is to make a profit by advantageously trading futures contracts (buying low and selling high, or selling high and buying low). Although this activity is often portrayed negatively, speculative trading is essential in adding cash to the market, referred to as ‘liquidity’. Liquidity is necessary in enabling hedgers to buy or sell contracts. Without speculative trading, hedgers would have to rely exclusively on each other to make opposite transactions. Speculators build market liquidity by bridging the gap between the prices bid and offered by other commodity traders.