HOW DO FUTURES WORK?

Futures contracts allow players to secure a specific price and protect against the possibility of wild price swings (up or down) ahead. To illustrate how futures work, consider jet fuel:

1. An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy a futures contract agreeing to buy a set amount of jet fuel for delivery in the future at a specified price.
2. A fuel distributor may sell a futures contract to ensure it has a steady market for fuel and to protect against an unexpected decline in prices.
3. Both sides agree on specific terms: To buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.

In this example, both parties are hedgers, real companies that need to trade the underlying commodity because it’s the basis of their business. They use the futures market to manage their exposure to the risk of price changes.

But not everyone in the futures market wants to exchange a product in the future. These people are investors or speculators, who seek to make money off of price changes in the contract itself. If the price of jet fuel rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more in the futures market. These types of traders can buy and sell the futures contract, with no intention of taking delivery of the underlying commodity; they’re just in the market to wager on price movements.

With speculators, investors, hedgers and others buying and selling daily, there is a lively and relatively liquid market for these contracts.