A future (formally known as a futures contract) is a kind of derivative often used to take “bets” on the price of something increasing or decreasing. If an individual believed the price of something [a commodity or stock, for example] was going to change in the future, they could buy a future for that item and make money if the change in price occured.

When someone believes the price of something will go up in the future, they are “long”. When someone believes the price of something will go down in the future, they are “short”. This is where the term “shorting a stock” comes from--it just means that someone has taken a bet that the price of the stock will decrease in the future. While futures contracts were created for producers and suppliers to ensure they would get goods they needed in the future, they are now heavily used as a way to take bets on price changes.

A future is a way of speculation--that is, guessing--without owning the actual thing you are “betting” on. That way, someone can make money on the price of something like gold increasing without owning physical gold. Futures are also used by producers of goods to get good prices for purchases in the future. A corn producer could sell a futures contract for 100 tons of corn a year from now, just to ensure that they will have a buyer. On the other side, a bakery could buy a futures contract for 100 tons of wheat a year from now, just to make sure that in a year they are guaranteed to have wheat. This is way of reducing risk, as both parties can make sure they will get what they need (either the good or money).

Today, futures contracts are rarely executed to completion. Investors buy them in pairs [one long, one short contract] as a way to avoid having to actually hold the physical good. That way, they get the monetary benefit of a price change without having to acquire the underlying good when the contract matures.

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Posted
AuthorIsabel Munson
CategoriesDerivatives