What they Are Futures are a derivative investment. Rather than representing shares of ownership, like stocks, or a loan, like bonds, futures contracts are contractual agreements that derive their value from an underlying asset. Futures can be used to hedge certain price risks -- or to take on that risk by speculating on the future price of an asset.
How they Work Futures are an obligation to buy or sell a specific commodity -- say coffee, orange juice, corn, oil or gold -- on a set date for a predetermined price. A coffee futures contract is a bet on what way coffee prices will go. What happens to the coffee itself doesn't matter much to you as an investor if you are speculating in futures. Futures can be used to reduce risk. The classic example is the farmer who agrees to sell grain at a good price using a futures contract, thereby getting protection if the price of the grain later falls. The wheat farmer may like the price that wheat is going for today, but fears the price will be down when he or she has it harvested and ready to sell six months down the road. The farmer buys futures contracts on wheat today, locking in today's price. If the price does fall, the farmer will get today's higher price. If the price rises or stays the same, the farmer is just out the cost of buying the futures contracts. However, investors who use futures are mostly speculators. A big attraction of futures is that they offer investor the opportunity to make big returns on relatively small investments, what's called leverage. The flip side is that leverage can also lead to huge losses if misused. For example, you can buy a futures contract worth thousands of dollars with an initial payment of about 10 per cent of the total value. So if you buy a gold contract worth $30,000 (U.S.) when the precious metal is trading at $300 an ounce, your cost would be about $3,000; your leverage would be roughly $27,000. Each time the pr ice of the gold futures contract rises by 10 cents, the value of your investment goes up by $10. If the price of gold falls 10 cents, you'll be down $10, money you'll be asked to pay immediately. If the price falls by $10, you'll have to come up with another $1000 immediately.
The Risks Futures contracts are both complex and extremely risky for the novice investor who speculates in them. Your potential losses could be unlimited if the price moves against you.
The Rewards If you use futures as a speculator and the price moves the way you hope, you could earn huge returns on a relatively small investment. If you use futures instead as a hedger, to guarantee a price on a commodity, they can be used to reduce risk.