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Futures

Futures are a type of financial instrument where the buyer purchased the underlying commodity for a specified price at some time in the future. The specific item traded is a futures contract.

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Expanded Definition

A "future" or "futures contract" (typically used interchangeably) is an agreement between two parties where one side buys a specific amount of a commodity (metals, grains, oil, etc.) at a particular price, to be delivered and paid for on a particular day in the future. For that guaranteed price, regardless of what the actual price is when the contract comes due, the buyer pays a premium.

These are a form of derivative security in that their price (the premium) is determined by the price of the underlying commodity.

The contracts are standardized and trade on an exchange, just like options do, but unlike some other derivatives such as credit default swaps.

These contracts allow people like farmers who are planting, say, corn in the spring to know exactly what price they'll be able to sell it for after harvesting. This takes a lot of risk out of the equation for the farmer (or miner in the case of metals) and thus is valuable for hedging.

Futures are similar to options, except where the option gives the buyer a right, but no obligation, to purchase the underlying item, the buyer of a futures contract must buy the underlying if he or she holds it to maturity. Of course, the futures buyer can always close the (long) position by selling (going short) an identical contract. If that short contract has a higher premium than the long one did, then the futures trader made money.

It is this possibility of making money by going long (buying) or short (selling) future contracts as the underlying price of the commodity rises or falls that has led in recent times to the large increase in futures trading. Most contracts do not last to maturity as they are closed by taking the opposite position before then, so no actual commodity trades hands.

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