Futures and Forward Contracts

Unlike options, which give the purchaser the right to buy or sell a security at some point without requiring them to do so, a future is an actual contract to buy or sell something in the future and, theoretically, requires actual delivery of whatever the futures contract covers. In most cases, the something that an investor is agreeing to buy or sell with a futures contract is a commodity. By definition, a commodity is a product that does not vary substantially among vendors and, therefore, can be standardized. In the futures market, the commodity is usually some type of raw good used as part of a larger production process, such as oil, gas, precious metals, or bulk food (grains, meat, etc.). The idea is that there isn’t that much difference between a bushel of corn from one farm versus another, so the price of a bushel of corn can be traded on an exchange. Futures are also traded on underlying financial instruments, such as interest rates, stock indexes, or currencies. These are called financial futures.

The original purpose of a futures contract was to ensure that producers of the commodities (farmers, miners, etc.) and the buyers of these commodities (stores, factories, manufacturers, etc.) could lock in their prices well in advance of the actual date the items would be needed or delivered. Since their original creation, though, investors have found futures contracts to be worthwhile investments to speculate on, since the prices of these items fluctuate substantially over time.

Futures contracts are different from options contracts in that both parties have an obligation. The seller has an obligation to make a certain delivery, and the purchaser has an obligation to accept and pay for this delivery. There is no premium paid by either the buyer or the seller for the contract, because each party owes an obligation to the other party.

With a futures contract, both parties must open a position. Buying a futures contract is