A primer on futures contracts

A futures contract promises to deliver today’s value of an index or product on a certain date in the future. In essence, sellers of futures are hedging long positions by locking in the price. Buyers are speculating.

If you buy a futures contract, you promise to pay to the seller the contract price of the index or product on the date the contract expires, say, 90 days hence.

The investment is risky because if the price drops you have to pay the difference between the contract price and the price on the day the contract expires. If the price rises, however, you pocket the difference.

The risk can be magnified because futures contracts can be bought on margin and investments can be substantially leveraged. That increases an investor’s exposure if the price falls, but also increases the potential to profit.

Think of it in terms of a potato farmer. Before the crop is harvested he may be happy with the current price of spuds.

He locks up that price by selling his crop on that day, for delivery in, say, three months. Thus, he protects himself, if a bumper crop depresses potato prices at harvest time.

The buyer of the contract, who make have insight on the market, is gambling that the price of potatoes will rise by harvest time.

If he’s right, he can take delivery of the potatoes at the contract price, sell them at the higher price and pocket the profits.

If he leverages his contract by paying the farmer, say, 10% down, he can vastly increase the number of futures contracts he can buy, and vastly increase the return on his investment — or his ultimate loss, if the price goes south.