Not everyone likes living in the present. Especially traders. They prefer planning finances for the future in the present for one universal reason – to be ready for contingencies in the time to come. Having said that, traders are only human,and always don't have clarity for making informed decisions for the time that is yet to pass by. But the effect of the severity of future emergencies can somewhat be in their control if they make use of the right investment instrument. For eg, if the trader sells chocolates, he must ensure that an increase in the future price of cocoa shouldn't affect his future sales. For this he can enter into a contract that safeguards his interests against inflation.This contract is called the futures.
Futures are financial contracts that make it obligatory for buyers to purchase, or sellers to sell, commodities or assets like a financial instrument at a predetermined future date and price (also called futures price). The futures contract comes with complete details on the quality and quantity of the commodity or asset,and are standardised for the purpose of trading on a futures exchange.
However,don't confuse futures with options. The difference between the two is that the latter gives the holder the right to buy or sell the commodity or asset at expiration, while the one holding a futures contract is obligated to fulfill the terms of his contract. But a futures contract can come with options that give the initial holder the right to enter the long side of the contract and buy the commodity or asset at the futures price. The short side of the contract makes it obligatory for the seller to sell the commodity or asset at the futures price. Now there can be either of two players in the futures market – hedger and speculator.
A hedger buys or sells in the futures market to secure the future price of the commodity or asset to be sold at a later date in the cash market. This helps the hedger protect himself against price risks. Hedger buying a commodity always tries to secure the lowest possible futures price, whereas a hedger selling a commodity always tries to secure the highest futures price. The futures contract comes with a definite futures price certainty for both buyer and seller, thus reducing risks associated with price volatility.
A spectator however looks at profiting from the futures price change that hedgers protect themselves against. Hedgers minimise risk, while spectators maximise risk for maximising profits.
Futures contract typeHedgerSpectatorShortSecure futures price now as security against future declining pricesSecure futures price now in anticipation of declining pricesLongSecure futures price now as security against future rising pricesSecure futures price now in anticipation of rising prices
Oh, there's one more – spot price
Unlike futures price, spot price is the current rate at which goods can be bought or sold at a specified time and place. A good’s spot price is the unambiguous value at any given time in the marketplace. However, the spot price of a commodity can be affected by its supply and demand. For eg, the price of precious metals go up in difficult times, thus resulting in anticipation of the possible increase in demand for the metals.
Spot prices are used for pricing of futures contracts of commodities, derivatives or assets. It is calculated using the commodity’s spot price, the risk free rate of return, and time taken by the contract to mature (including costs associated with storage or convenience). Similarly, spot price can be determined using the futures price.
So if you are a trader reading this article, you have learnt what it means to keep your eyes on the futures price of commodities. After all, business one started should only keep growing, unaffected by unforeseen events. And if you are an investor, you are now more informed to decide if you want to be the hedger, or the spectator.