What the Heck is a Futures Contract?

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What the Heck is a Futures Contract?

Lots of people talk about futures, but what are they really? Why do you care? Because trading futures, if you use the right system, can be your path to great wealth.

To understand what we mean by a futures contract, let’s meet trader Bob (a buyer), who wants to purchase a widget today because he believes that the widget will have more value in the future. If all goes well, Bob will buy the widget now, wait for the price to go up, then sell the widget for a small profit in a month. But where can Trader Bob obtain the widget? It so happens that Trader Sam (a seller) has in his possession the widget that Trader Bob wants. Trader Sam would like to sell the widget today because, unlike Trader Bob, he believes that the widget will have less value in the future than it does today. Trader Sam is selling today because he believes that he will make more money now than if he waits to sell in a month.

So Trader Bob and Trader Sam get together and agree upon a price for the widget. Trader Bob is now the proud owner. If the value of the widget indeed increases in the future, then Trader Bob can become a seller and part with the widget with a profit. If the value of the item decreases in the future then Trader Bob will have to sell the widget for a loss.

This basic relationship between buyer and seller is the foundation for all commerce. Futures are simply a variation on this theme, where instead of buying a widget now, Trader Bob contracts to buy the widget in a few months at a fixed price. The transaction still relies on the buyer believing the price will go up, and the seller believing the price will go down.

Trading Critters

Futures traders fall into two categories: hedgers and speculators. The primary economic purpose of the futures market is for hedging, which is buying or selling futures contracts to offsets risks of changing prices in the cash markets. Hedge traders, such as large commercial firms that may actually take delivery of certain commodities, like coffee or wheat, use futures contracts to protect (hedge) themselves against changing cash prices.

Speculators, however, make up the majority of futures traders. Speculators have no commercial interest in the underlying commodity and have no interest in taking delivery of the commodity. The potential for profit is what motivates speculators to trade commodity futures. Speculators buy when they believe that prices will increase and they sell when they believe that prices will fall. Futures traders using STARS would be considered speculators.

Basic Basics

If a trader is a buyer, he has taken a long position. A long position involves the purchase of a futures contracts in the hope that the price of the contract will increase in the future. Let’s say our friend Trader Bob contracts in March to buy a widget (a long position) in June for $10. June rolls around, and the price of a widget is now $13. That means Bob now has the right to buy the widget for $10 even though the going rate is $13. Bob goes ahead and buys the widget for $10, then turns around and immediately sells it for $13, pocketing the difference.

A trader who is a seller takes a short position, which involves the sale of futures contracts in anticipation of prices falling in the future. Trader Bob in this case contracts in June to sell a widget in September for $13. Fall comes around, and the going rate for widget in September turns out to be $9. Trader Bob buys a widget for that going rate of $9, then immediately turns around and exercises his right sell the widget for $13, profiting from the difference. At first, it might seem odd that Trader Bob is contracting to sell something he does not yet own. But look at the situation this way instead: in June, Bob makes a commitment to sell a widget to Sam in September for a guaranteed price of $13. If Bob can buy the widget for less than that sometime before September, he will make a profit.

All of this is made simple and easy in a new book: A Simple Guide to Astronomical Wealth: the STARS Method of Trading Futures. Like Bob, you too can make huge profits by trading the STARS method.

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