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If you ever scheduled a July picnic using a weather trend as a guide for setting a date, you already understand the concept of future markets in finance. Using your basic knowledge of how the weather behaves in July where you live,you choose a date when you feel there will be little likelihood of rain. When you invest in futures, you use your knowledge of market trends to decide how an asset will behave over a given time and you choose to invest or sell.
What is a Future?
Investopedia states that a future is a “financial contract obligating the buyer to purchase an asset (or the seller to sell an asset) such as a physical commodity or a financial instrument, at a predetermined future date and price.” The contracts are generally specific in regard to the quantity and the quality of the asset, and are in standard form to make trading them on the futures market easier.
What is an Asset?
People trade futures in many things, both deliverable and non-deliverable. Assets can be things such as grains, oil, cattle, gold, silver and other things. There are so-called soft assets like cocoa, coffee and lumber, sugar, cotton and orange juice, and there are financial assets like bonds and currency. Futures trading even includes such things as interest rates, according to Futurestradingpedia.com. Investing in some assets, such as orange juice, can be risky because of the crop’s vulnerability to weather.
How Do You Make a Profit Trading in Futures?
You can “go long,” which means buy or “go short, “which means to sell in order to hedge your risks as a buyer or a seller. For instance, you probably know how the price of a pound of coffee fluctuates. That fluctuation is called volatility. The farmer may sell his unroasted coffee to a roaster for $5 a pound. The roaster will charge $15 a pound for the manufactured product. Both are satisfied with the arrangement, because both are profiting. Many things can affect the price of coffee, and the grower and the roaster seek to make a predictable profit. They may sign a contract with an investor that “hedges their bets.” They enter into a contract with a futures investor that says if the price for unroasted coffee beans goes above $5 a pound, the investor will make up the difference for the grower and the roaster will get his beans at the same rate.
If, however, the price for the beans goes lower, the roaster pays the agreed-upon amount and the investor keeps the profit. People contract to buy bonds at an agreed-upon interest rate and if the rate goes lower the seller still makes his profit. If the interest rate rises though, the investor keeps the profit. Futures represent a risk, but can be enormously profitable.
Success depends upon knowing the asset and its history as well as a bit of luck. Some people invest in futures with no intention of keeping them until the agreement expires. The contracts are sold on the market before they reach maturity at a time when the have reached an acceptable profit. This kind of speculative investing, especially in commodities, can affect entire economies. An investor who purchases, and thereby ties up, large quantities of oil, for example, may cause a shortage of the commodity. That causes prices of gasoline and fuel oils to rise. The investor profits from the perceived shortage in the oil. When the speculator sells the contract, there may be an oil glut that sends prices plummeting. These types of investing require huge financial output.
Related Resource: 5 Attributes of a Successful Banker
Scheduling a picnic, without knowing exactly what the weather will do is risky, but the prospect of a pleasant experience makes the idea attractive. The same is true of investors who speculate when playing the future markets in finance.
