Futures speculation is considered highly risky and is not suitable for most investors.
A futures contract in the stock market is an agreement between two parties regarding future delivery of commodities at a certain price. If you buy a futures contract, you are essentially agreeing to buy a product at some point in the future at a price agreed upon today. For example, a coal mining company might sell futures to an electric company, promising to deliver coal at a certain date in the future at a predetermined price.
History
The futures market began in Chicago during the 19th century in response to inefficiencies in the agricultural market. Before this market developed, farmers who grew their crops were at the mercy of the market. If too many farmers grew the same crops, they might flood the market at harvest time, causing prices to drop. Today, futures contracts allow farmers to sell their crops before they grow them, locking in the price they will receive ahead of time. These contracts help avoid market gluts. For example, if there is no demand for wheat futures, a farmer may choose to grow corn instead.
How Futures Work
A futures contract is like an invoice for a product that will be delivered in the future. For example, when you buy a cellular telephone, you might agree to buy a certain number of minutes each month over the next year. The contract you make with your phone company is similar to a futures contract, for you have agreed to buy a certain product at a future date at a price you agree upon today.
Hedging
Companies that mine or produce commodities, such as coal, steel and oil, and farmers who grow livestock and crops, use futures contracts as a hedge against future price risk. For example, if you are a farmer, you want to guarantee the price you will receive for your crops before you grow them and not be left to the mercy of the market at harvest time. Thus, you sell a contract to buyers today, agreeing to deliver your crops in the future for specific price.
Speculation
Once a futures contract is created, the contract itself is bought and sold just like a stock. New market developments influence the price of the contract. For example, a futures contract that guarantees a price of $10 a bushel for wheat will grow in value if the price of wheat drops to $8 a bushel because it guarantees delivery at a price better than the current market. Speculators, who never intend to take wheat delivery, buy and sell contracts to one another before the contract expires.
