Futures Explained

Investors are often driven to invest in something that has yet to happen. While buying securities today and holding them in anticipation of a price movement can involve locking up capital, buying a futures contract instead can be a lower cost alternative. Futures are, in essence, contracts that allow you to buy something at a certain price at a specific point in the future. This is particularly useful since the holder can capitalize on the power of leverage. In other words, by putting a relatively small amount down to buy the future, the investor still benefits from any upside movement.

Futures are most often based on stocks, commodities, and market indices. Unlike options, futures are characterized by an obligation to fulfill the terms of the contract. Settlement at expiration can involve physical delivery of the asset or an exchange of cash. Consider a tofu producer that is concerned about the rising costs of soybeans. If soybean prices continue to rise, the tofu company may see a reduction in its profits. To minimize the impact of this, the company enters into a futures contract allowing it to purchase soybeans at a fixed price at a specific point in the future. In doing so, the company has locked in a fixed price for its soybeans and created an effective hedge against rising prices. A speculator could buy the same future with the hopes that soybean prices may continue to rise thus secure what may prove to be a lower buy in price. Of course, if soybean prices drop, the contract holder will suffer a loss.

Futures, like most derivatives can be used for hedging as well as speculation. And, like most derivatives, they come with significant risk and can prove highly volatile.

Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com .

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