Ask TheStreet: Future Feature

Editor's Note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment or stock-related advice.

---

I watch CNBC before the market open and they predict a higher or lower open based on indicators called "futures." What are they? Thanks, M

Gregg Greenberg: Futures trading has been around for centuries, but it still remains a somewhat difficult-to-grasp concept. It started with farmers using forward contracts, which are agreements to buy now, but pay and deliver later, as a means of getting farm commodities like grain and rice from producers to consumers, at fixed prices and delivery terms. Since those early agrarian days, futures markets have evolved to incorporate not only commodities, but currencies and, per your inquiry, stock indices.

Perhaps the best way to start is by offering a definition of "futures" direct from the Chicago Mercantile Exchange, the largest futures exchange in the U.S.:

"Futures are contractual agreements made between two parties through a regulated futures exchange. The parties agree to buy or sell an asset -- livestock, a foreign currency, or some other item -- at a certain time in the future at a mutually agreed upon price. Each futures contract specifies the quantity and quality of the item, expiration month, the time of delivery and virtually all the details of the transaction except price, which the two parties negotiate based on current market conditions."

Now let's try and illustrate this definition using, say, a nervous corn farmer. It's June and the farmer is anxious that a glut of corn will cause prices to plummet before he gets his crop to the market in August.

In order to hedge his risk, the farmer enters into a futures contract to sell his corn in August for a specific price. In other words, he creates a "short" position in the futures market -- a bet that prices will fall, making his deal a good one.

Who would take the other side of this deal? Perhaps a big corn user like Kellogg(K Quote) that might be afraid of rising prices and wants to guarantee the supply of corn to its cereal factories.

Now let's skip ahead to August. The glut the farmer predicted comes to fruition and the price of corn is lower on the delivery date. He closes out his short position by delivering the corn to Kellogg at the agreed-upon price.

There you go. One happy farmer used a futures contract to protect himself from a drop in prices.

Kellogg's corn buyers, on the other hand, may be kicking themselves because they could have waited and purchased their August corn at a cheaper price.