h2g2 The Hitchhiker's Guide to the Galaxy: Earth Edition

A futures contract is an agreement between two parties where one agrees to sell to the other a specified quantity of a specified quality of a specified commodity at a price agreed today for delivery on a specified date in the future.

I often have used an analogy of dining room furniture to explain the concepts of futures and option contracts. Confused? Read on!

Still confused?

OK, let's go shopping......

Say that you have it in your mind to buy a new dining room setting. You visit the store and pick out a lovely 7 piece setting listed at $1100. You speak to the assistant and agree to purchase the setting for $1000, then asking for some help to get the setting out to the utility van that you have parked in the street.

"Oh no", the assistant replies, "you don't want THAT setting, it's chipped and marked. We will order a brand new one for you that is in top condition". On hearing that it will take only 2 weeks for this delivery, you agree and pay your deposit.

What have you done?

You have agree to buy a specified quanitity (1) of a specified quality (no marks, brand new) of a specified commodity (dining room setting) at a price agreed today ($1000) for delivery on a specified date in the future (2 weeks).

You have entered into one type of futures contract.

Conceivably, were the price of dining room furniture to change, you might be able to sell your right to buy a setting at $1000 for a profit. If the store fails to deliver, you might be in a position to seek damages.

And there's more.... if you were opening a restaurant, you might be after 45 settings - a contract to buy only one would be useless. However, 45 settings would not fit in my house. If I were to contract to buy 45 settings, I would be doing so on the basis that I thought that the price would increase and that I would be able to "close out" (or take out a contract that is the opposite position) at a profit. I would be a speculator on dining room furniture.

And that's not all.... How is it that the store can contract to sell you something that does not exist? The timber might at that moment still be happily growing as a tree.

The store has a wholesale price list in which the manufacturer effectively gives the store an option to purchase a setting at the agreed wholesale price. In turn, the manufacturer has timber supplies and labour available to manufacture the setting at a cost that will allow a profit to be made.

When you look at things like this, you realise that futures contracts and the like are all around us. The danger in financial futures for private investors is the extent of leverage. But if positions are controlled, there will be no need to fill your house with tables, waiting for a timber shortage!