How do futures contracts work?
February 10th, 2010 | by admin |I have read a lot on futures contracts, but the actual way in which they work confuses me.
Say i have 100 tonnes of wheat to sell. I put out a futures contract, because the price in 6 months time is higher than the price today. So ive locked in that price.
Now anyone can buy that contract and sell it on right?
So when it times come for the contract to expire or whatever, how do you know who you are delivering too?
And whats the deal with settlement?
I know the MLA Beef futures contracts were cash settlement only, so if i were selling cattle, that means i can only get paid in cash right? why would i want to be paid in anything else?
and whats the deal with closing contracts? by switching your position and either buying or selling depending on what you were doing in the first place…
now in a pdf i was reading, in all the examples, the beef producer sold their futures contract at a high price, and when it came to the end of the contract, they bought it back, and then sold on the physical market.
how does that work? what if the person who bought the contract didnt want to sell the contract back to the original buyer? this is where i get lost…
but surely u have to own the physical commodity to put the contract up for sale in the first place? like the very first contract
i cant invent/ creat a new contract for wheat if i dont own any right?
You don’t have to hold the physical commodity to trade futures. In fact most people don’t.
In your cattle example that person didn’t need to own the cattle to do the first part of the transaction. They sold a long futures contract at a high price and speculated right. When the contract was expiring they simply bought the contract back at a lower price and the difference was their profit.
They didn’t necessarily buy back the contract they sold, they just bought back the same number of contracts they sold to close out their position relieving them of their obligation to deliver the cattle.
The problem with futures are they are greatly leveraged/margined.
You need to maintain a certain margin balance in your account to keep your position or you get a margin call.
In an extreme case you could lose everything you own.
One Response to “How do futures contracts work?”
By Splattie on Feb 10, 2010 | Reply
You don’t have to hold the physical commodity to trade futures. In fact most people don’t.
In your cattle example that person didn’t need to own the cattle to do the first part of the transaction. They sold a long futures contract at a high price and speculated right. When the contract was expiring they simply bought the contract back at a lower price and the difference was their profit.
They didn’t necessarily buy back the contract they sold, they just bought back the same number of contracts they sold to close out their position relieving them of their obligation to deliver the cattle.
The problem with futures are they are greatly leveraged/margined.
You need to maintain a certain margin balance in your account to keep your position or you get a margin call.
In an extreme case you could lose everything you own.
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