The simplest explanation of futures contracts
Futures Contracts: A Simplified Explanation
Futures Contracts are simply agreements to buy or sell a specific asset (commodity, currency, stocks, etc.) at a specified price on a future date.
Imagine agreeing today to purchase a specific commodity, such as a barrel of oil, not at today’s price, but at a price you both agree on now, with delivery and payment to occur later (e.g., after 3 months).
Here’s a simplified breakdown of the concept:
Contract Parties
* Seller: commits to selling the asset in the future at the agreed price.
* Buyer: commits to purchasing the asset in the future at the agreed price.
Contract Components
* Underlying Asset: is the commodity or financial instrument that is agreed to be sold or purchased (e.g., gold, oil, wheat, stock index, a specific currency).
* Strike Price or Futures Price: is the price that is set today to complete the transaction in the future.
* Delivery Date or Expiration Date: is the future date when the buying and selling must occur.
* Contract Size: defines the standard quantity of the asset agreed upon in a single contract (e.g., 100 barrels of oil, 5000 bushels of wheat).
Why use futures contracts?
Futures contracts are primarily used for two main purposes:
* Hedging:
They are used by producers and consumers to protect themselves from price fluctuations. For example:
* A wheat farmer can sell futures contracts on his future crop today at a certain price to secure a fixed income, regardless of a decline in wheat prices at harvest.