Futures contracts are financial assets just like stocks and bonds, but with some important differences. These differences are what make futures such an appealing investment for traders.
What is a Futures Contract?
A commodity futures contract is a firm commitment to deliver or receive a specific quantity and quality of a commodity during a designated month at a price determined by open auction on a futures exchange.
You can buy a futures contract on gold, lumber, pork bellies, swiss francs, and many other items. The underlying item or commodity is described specifically in the contract specifications which are determined by the futures exchange on which it trades. The price of a futures transaction is agreed upon initially between the buyer and seller, and remains fixed over the holding period, or length of the contract. The small amount of money that you need to deposit for buyers and sellers of a futures contract is called margin. Finally, the full price of the commodity must be paid only upon contract expiration at which point you take delivery, if you bought futures, or make delivery, if you sold futures, of the underlying commodity. Don't worry. You don't have to make or take delivery if you don't want to. You can instead offset or square your position prior to the contract's expiration.
Understanding a Futures Price
When you buy a futures contract, the price represents the price at which you are committed to buying the underlying commodity when the futures contract expires. Similarly, when you sell a futures contract, the price represents the price at which you are committed to selling the underlying commodity when the futures contract expires. (Not all futures contracts require physical delivery upon expiration, some are simply settled by cash.) For example, if you buy a COMEX December gold futures at $380 per ounce, then you have the obligation to buy 100 ounces of gold at a price of $380 per ounce in December when the futures expires. (COMEX, which stands for the Commodities Exchange in New York, is the futures exchange on which gold futures trade. COMEX has set the quantity of gold underlying the contract at 100 ounces.) The price of gold futures constantly fluctuates in response to several factors such as supply and demand, interest rates, and prices of other precious metals. However, no matter what the price of gold does after you buy the futures, you will be able to buy gold at the price of $380 per ounce - you have locked in this purchase price.
Futures as an Investment
When you buy a futures, you lock in a purchase price for the underlying commodity. Similarly, when you sell a futures, you lock in a selling price of the underlying commodity. If prices go up after you buy a futures contract, then you earn profit since the futures contract has increased in value.