Forward contracts
A futures is an exchange-traded forward contract.
Commodity producers and goods manufacturers have used forward contracts for many years. For example, the producer of coffee beans may want to lock in the price at which he will be able to sell his harvest. In this way, he protects his business if the price of coffee beans drops in the future and he won’t be able to cover production costs. On the other side, the manufacturer of ground coffee is worried about the price of coffee beans rising, which would make him pay more in his turn for manufacturing his product.
To protect themselves from such risks, producer and manufacturer enter into a forward contract agreement. One party agrees to sell a particular amount of commodity on a predetermined future date at a fixed price (being, what is called, “short”), and the other party agrees to buy that amount at that price and on that date (being “long”).
If the market price of the commodity at the time of contract honouring will be lower, than the price fixed in the contract, the commodity producer gained profit on his contract, because he can now sell at the higher-than-market price. Conversely, if the price will be higher, the buyer of the commodity will make a profit, because he can now buy at the lower-then-market price.
The forward contract might get too disadvantageous for either side during its period if the real-time market price of the asset moves too much away from the agreed-upon. Since neither party can cancel the contract, they can agree to novate it. What happens, in this situation, is that parties swap their sides and the buyer of the commodity agrees to sell it back after it gets delivered to him according to the initial contract agreement.
Simple example
You enter into a forward contract to deliver (sell) one ton of aluminium at $2,000 price in three months. One month in, the cost of aluminium per ton is at $2,500, and your initial contract is much less beneficial for you since you would now have to sell something worth in open market $2,500 for only $2000 (your net loss is -$500).
To limit your losses, if the price of aluminium moves higher, you reach an agreement with the buyer to novate the contract, in which he agrees to deliver you that same one ton of aluminium back at the price of $2,500 at the date of the contract expiry. The outcome of this is that you fix your potential losses to $500 since you deliver your product for $2,000 and then get it back to you for $2,500, even if the price goes to, let’s say $3,000.
One party ends up with a net loss of $500 which are pocketed by another party.
Traded forward contracts are futures
If you think more about this, no real delivery of actual physical asset needs to happen here, and the profit/loss difference can be settled directly in cash between parties. But, if you think even more about it, and this is where it’s getting exciting, you don’t have to novate your contract with the same party you set up your forward contract initially.
In the example above, you can find the third party, which will agree to sell you one ton of aluminium at $2,500 at the same expiry date as the first contract. So when both contracts expire at the same time, you limit your losses to $500. But since you have already fixed your potential losses, you don’t have to wait until the contract expires, you’ve realised your loss by going “short” and then “long”, and you’re out of the market.
Conclusion
This example, with three parties, is the essence of futures trading. In reality, most futures trading occurs without physical delivery of any asset whatsoever and the number of parties entering and exiting these contracts is unlimited. Standard sizes of contracts and preset expiry periods is what distinguishes futures from forwards and allow trading on exchanges between multiple parties.
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