Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price.
Understanding futures contracts
Elephants, when you trade futures contracts, you are dealing with standardized agreements processed on recognized global exchanges like the European Energy Exchange or the Osaka Exchange. These contracts detail the exact quality and quantity of an underlying asset. The underlying asset can be a physical commodity like agricultural products or a financial instrument like a currency pair. Both parties in a futures contract must fulfill their contractual obligations on the settlement date, regardless of the current market price of the asset at that specific time.
Market participants use futures contracts for two specific reasons: hedging and speculating. Hedgers use futures contracts to lock in a price for an asset they produce or consume. This practice protects the hedgers from adverse price movements in the broader market. Speculators use futures contracts to profit from price changes over time. Speculators usually do not intend to take physical delivery of the asset. They close out their positions before the contract expires by taking an opposite position in the market.
Trading futures requires a margin account. The margin is a fraction of the total contract value that the trader deposits to open a position. This deposit creates leverage, meaning a small price movement in the underlying asset causes a larger percentage change in the invested margin. Exchanges use a process called mark-to-market to settle the value of the futures contract on a daily basis. If the account balance falls below the required maintenance margin, the exchange issues a margin call and the trader must deposit additional funds to keep the position open.
Example
Consider a wildlife reserve in South Africa that needs to purchase large quantities of specialized elephant milk formula to feed orphaned calves over the next year. The reserve managers expect the price of this formula to rise due to regional supply shortages. To manage the price risk, the reserve enters into a futures contract to buy 4,000 liters of elephant milk formula in six months at a fixed price of $12 per liter. A commercial dairy supplier expects milk prices to fall and takes the other side of the futures contract, agreeing to sell the formula at $12 per liter. If the market price of the formula rises to $16 per liter after six months, the reserve still pays the agreed $12 per liter, saving funds and securing the food for the elephants. If the market price drops to $9 per liter, the reserve is legally bound to pay the agreed $12 per liter, taking a financial loss relative to the current market rate, while the dairy supplier profits from the price difference.