There are many investment options on the market and a future contract is only one of many derivatives. It may not be as complex as other derivatives but it is a valuable instrument if you want to make sure you know what price you are buying or selling an item for in the future.

A future contract is a standardized contract which is traded on a future exchange. With a future contract you buy or sell an underlying asset (this can be a product, a stock or bond etc) at a certain pre-determined date in the future. This future date is then called a final settlement date or the delivery date. There is a pre-determined price; the future price and the price of the underlying asset at the delivery date are called the settlement price.

A future contract is one way for an investor to hedge his position. If he believes that the price of an asset will rise in the future, then he will buy a future contract. His position is called to go long. On the other hand, if he believes that the price will fall, he wants to go short. That means that he want to buy a future contract.

The future contract differs from options in the way that futures give both the buyer and the seller of this derivative the obligation to carry out the contract. Had it been an option, the buyer would have hade the right but not the obligation to settle the contract. This means that future contract is a zero sum game. That is, the gains that one party will make are going to be the other party's loss.

Let's say that we have a buyer and a seller of apples. Today the price of apples is US 500 per barrel and the apple buyer is price sensitive. He can't afford to pay more than US 530 a barrel and he under the impression that the price of apples will go up. He looks at the future exchange and sees that he can buy a future contract for a barrel of apple where he has to pay US 525. He agrees and so he goes long while the seller goes short. The final settlement date is declared and the buyer and seller are happy.

On the delivery date we have two scenarios:

Scenario 1; the prices of apples have risen incredibly. Today one barrel of apples is prices at US 750. The buyer is very happy that he hedged his position as he now can buy the barrel for the future price of US 525. The seller has to forgo a US 225 price hike.

Scenario 2; the prices of apples have fallen and are now selling at US 450. The seller is extremely happy as the buyer is obligated to pay the pre-determined price of US 525.

The reason why there is a market for these derivatives is that not everyone likes the idea of a market that fluctuates. With the help of futures, buyers and sellers can guarantee prices in the future and any price loss would be seen as the price you have to pay to know the settlement price.

As futures are complex derivatives this is not a financial instrument for everyone. The loss can be substantial if we are talking about hedging a position were there is more than one barrel of apples. In order to use these future contracts you will need an in-depth knowledge of the financial market and various derivatives. You will also have to have the money to back you if you make a bad decision. These futures are often used by major players on the market that have the knowledge and financial backing to handle the situation.

Learn more about this author, Camilla Persson.
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