Futures Markets Explained Simply
Published · Updated · 4 min read
Futures markets are often associated with financial traders. They grew out of the physical trade, though: producers, merchants and processors needed a way to fix a price before goods were harvested, delivered or sold. Today both groups trade the same contracts - commercial firms hedging physical business and financial participants such as funds.
What a futures contract actually is
A futures contract is a standardized, exchange-traded agreement to buy or sell a fixed quantity of a commodity at a set price on a set future date — for example 5,000 bushels of wheat, delivered in July, at today's agreed price. "Standardized" is the key word: unlike a private handshake deal with a buyer, the quantity, quality grade and delivery terms are fixed by the exchange (CME, Euronext and others), which is what makes the contract easy to trade and easy to exit before the delivery date arrives.
Why producers and buyers use them: hedging
Hedging means using a futures (or forward) contract to lock in a price now for something that will be sold or bought later. A farmer planting wheat in the fall for a harvest next July doesn't know the price seven months from now, and neither does the mill that will need that wheat. Selling futures against the expected harvest fixes a price for the seller; buying futures does the same for the buyer. If the cash price later comes in lower, the seller's gain on the futures position roughly offsets the lower price on the physical sale, and vice versa. The point isn't to guess right — it's to take the price uncertainty out of the budget.
Basis: why the local price is never exactly the futures price
The quoted futures price is a national or regional benchmark, not what a local buyer actually pays. The gap between the two is basis — driven by distance from delivery points, local supply and demand, storage costs and the quality of what is actually delivered. A hedge locks in the futures price; the realized price is still futures price plus (or minus) basis, so basis risk doesn't disappear just because the futures leg is hedged.
A simple example
Say it's March and July wheat futures trade at $6.00/bu. A farmer expecting to harvest in July sells a futures contract at $6.00. By July, two things can happen: cash wheat has dropped to $5.20 — the farmer sells the physical crop at $5.20 but the futures position gains roughly $0.80, netting close to $6.00 overall. Or cash wheat has risen to $6.80 — the physical sale brings in more, but the futures position now loses roughly $0.80, again netting close to $6.00. Either way, the outcome lands near the price locked in back in March, which is exactly what the hedge was for.
Who else is in the market
Processors and exporters hedge on the buying side, locking in an input cost instead of a sale price. Financial traders with no intention of ever delivering or receiving actual grain also trade the same contracts and supply much of the volume and liquidity that makes it possible to enter and exit a hedge quickly. How much influence that purely financial trading has on the underlying price level is debated in the research.
Where hedging stops helping
A hedge fixes a price, not necessarily the best price — if the market rallies hard after a seller has hedged, the upside on the hedged portion is given up (for a buyer, the same applies when prices fall). Futures positions can also require margin (cash posted while the position is open, which can call for more cash if the market moves against the futures leg before the physical sale closes it out), and basis can still move independently of the futures price. Hedging trades away uncertainty, not risk of a specific bad outcome — which is exactly why it's a budgeting tool, not a way to guarantee the highest possible price.
Next article: Understanding Volatility.
Frequently Asked Questions
- What is a futures contract?
- A standardized, exchange-traded agreement to buy or sell a fixed quantity of a commodity at a set price on a set future date. The quantity, quality grade and delivery terms are fixed by the exchange, which is what makes the contract easy to trade and easy to exit before delivery.
- Why do producers and buyers use futures contracts?
- To hedge - locking in a price now for something they'll sell or buy later, removing the guess of where the price will be from their budget, not to bet on which direction prices will move.
- Why isn't the futures price the same as the local price?
- Because of basis - the gap between the national or regional futures benchmark and the local price, driven by distance from delivery points, local supply and demand, storage costs and crop quality. A futures hedge locks in the benchmark price, not the local one.
- Does hedging with futures guarantee the best price?
- No. It fixes a price, not necessarily the best one - if the market rallies after hedging, that upside on the hedged portion is given up. Hedging trades away uncertainty, not the risk of a specific bad outcome.