Futures contracts are standardized instruments, settled daily through the exchange on the settlement price agreed between two parties. A futures contract is an agreement between a party who agrees to sell a commodity (short position) and a party who agrees to receive a commodity (long position).
When investors expect the price of an underlying asset to rise, they take a long position. If the price rises, the holder will make a profit by selling the futures contract or take delivery of the underlying asset on the specified date at the settlement price that would be lower.
To better understand how futures contracts are settled, we assume that in March, a corn producer is looking to lock a selling price for next season’s crop, so he is taking a short position, while a bread maker is looking to lock a buying price, so he is taking a long position. The two parties may enter a futures contract for the delivery of 5,000 bushels of corn to the bread maker in August at a settlement strike price of $5 per bushel. By entering into a futures contract, both parties agree on a price to pay and receive in August.
If the price of corn increases to $7 per bushel, the corn producer, who has the short position, is losing $2 per bushel and he has to sell higher. The bread maker, who has the long position, is earning $2 per bushel as the buying price he has agreed to pay by entering the futures contract is lower ($5) than the price the market is asked to pay in the future for the corn ($7).
If the price of corn increases, the corn producer's account is debited $10,000 (5,000 bushels x $2 per bushel) and the bread maker's account is credited by $10,000 (5,000 bushels x $2 per bushel).
If the price of corn decreases to $3 per bushel, the corn producer, who has the short position, is earning $2 per bushel and he can sell lower. The bread maker, who has the long position, is losing $2 per bushel as the buying price he has agreed to pay by entering the futures contract is lower ($3) than the price the market is asked to pay in the future for the corn ($5).
If the price of corn decreases, the corn producer's account is credited $10,000 (5,000 bushels x $2 per bushel) and the bread maker's account is debited by $10,000 (5,000 bushels x $2 per bushel).
Unlike the stock market where profits or losses are realized when short positions are covered, futures contracts are settled daily. Daily settlement is made either by physical delivery or by cash settlement.
Physical delivery would mean that 5,000 bushels of corn would be delivered by the corn producer to the exchange and by the exchange to the bread maker. Physical delivery is mostly common with commodities, but in practice, it hardly ever occurs. Typically, futures contracts are settled before maturity with cash settlement. Cash settlement occurs when the underlying asset, i.e. the bushels, cannot be physically delivered and therefore the positions are closed with a cash payment at the settlement price. Besides, cash settlement is more preferable for sellers who wish to enter the transaction without having actual possession of the underlying asset.
Overall, futures contracts are considered a risky investment that should be used by savvy investors and institutions. Generally, futures trading requires taking into consideration the risk involved that is related to market fluctuations.
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