In the previous article we discussed the origins of Futures markets, now let’s see how they basically work.
To recap, futures are derivatives in which the value depends on the underlying asset it is derived from. For example, the value of Gold futures will depend on the price of Gold (gold here is the underlying asset). It is said to mirror the real price of a certain commodity and many players also use Futures as a prediction of where the price of the actual commodity will be heading to. In other words, generally when the price of Gold increases in value, so will the Gold futures.
A futures contract can be described as an agreement set between two parties in which one party, the buyer, agrees to buy from another party, the seller, an underlying asset at a future date at a price that both parties agreed on today.
An underlying asset can be defined as the asset on which the price of a derivative, in this case the futures contract, depends on.
For example, let’s say Dorian decides to have a Fastfood meal delivery for lunch and he calls the toll free line to place his orders. The order he places with Fastfood is similar to a futures contract.
This is because Dorian (the buyer) has agreed to receive a product (burgers and fries) at a future time (40 minutes later), with the price (price of his meal) and terms of delivery (his provided address) which were set with the seller beforehand, in this case with Fastfood.
Should Fastfood decide to increase the price of their burgers and fries within the next 40 minutes, although it will likely never happen, Dorian has locked in a lower price for his meal and will not face the risk of paying extras.
Bear in mind that although futures are not as simple as a Fastfood meal, this example illustrates futures with as little technical complexity as possible. We should get into what the basis of futures really is before going deeper.
It is important to remember that a futures contract is an obligation to buy or sell an underlying asset, normally a commodity, at some time in the future, at a price fixed upon today. This obligation must be fulfilled by the contracting individuals. It means that the buyer/seller is obliged to exercise the terms of the contract at its expiry date unless it is offset.
This can be done by offsetting the original position.
For example, let’s say John bought a futures contract. To fulfill the obligation, John can simply offset his position by selling what he bought.