Futures and Options -- Getting Started With Futures

Futures contracts and options both are derivative investments, meaning that they are investments based on another underlying investment. The key difference between the two is that options grant you the right to buy or sell an investment within a given time frame, while a futures contract represents an obligation to buy or sell an investment within a set period. (For more details, please see the Getting Started With Options entry.)

How do futures contracts work? An investor buys a contract to buy or sell an underlying investment in the near future. The underlying investment in the futures contract may be a commodity such as wheat, oil, sugar, orange juice or cocoa. There are also futures that are tied to the performance of financial items in the marketplace, such as currencies, interest rates and stock and bond indices. Many market participants track these financial futures as indication of which way the broader market is heading, so Wall Street (and TheStreet.com) monitor their movements.

For example, you may purchase a contract to buy sugar in October, meaning you purchased the October sugar contract. The price you paid is determined by supply and demand on the trading floor of a futures exchange, in this case the Coffee, Sugar and Cocoa Exchange in New York. The initial price of the contract is subject to the conditions affecting the underlying investment. So, in the case of sugar, if crop damage done to sugar cane due to certain weather conditions destroy a portion of the supply, prices will rise. An investor in futures contracts can either hold the contract until the expiration date and execute the sale, or trade the contract within the set time frame.

When futures contracts are entered into, an investor puts a small amount down, typically 10% or less, meaning you leverage, or borrow, the rest of the contract. For example, if you purchased a September wheat contract for $20,000, you would put $2,000 or less down.

There are two very distinct types of investors who purchase futures contracts: hedgers and speculators. Hedgers are typically people such as farmers or agricultural-products companies whose businesses are tied to the underlying commodity, and their profitability depends in part on securing a decent price for the underlying commodity that a futures contract represents. The futures contracts lock them in at a set price, protecting them from volatile price swings that often occur in the commodities market. For example, farmers often use wheat futures contracts to guarantee a certain return on their crops; or a clothing maker will use a futures contract to guarantee a certain price that it can buy cotton.

Speculators don't care a whit about the underlying product, except for the profit that changes in its price can deliver. These investors trade the futures, but never the underlying commodity. And, because of leveraging, these speculators can make a tidy profit if an investment goes well, or get crushed if it goes wrong. Speculators may purchase oil contracts on a bet, for example, that the oil-producing countries will curb production levels and limit the supply, meaning prices will rise.

Eyes on the Futures

If you're looking to monitor the futures market, look no further than TheStreet.com. We track movement in financial futures every day, and every week offer broader analysis of how futures affect the markets -- and you.

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