Written by Sahil Bloom:

Over the last several weeks, I’ve hit on the basics of some common forms of derivatives, including call options and put options. But there is more work to be done. So, let’s go Back to the Futures. Sorry, I’ll show myself out.

Here’s Futures 101!

Futures are a common form of derivatives. A futures contract is an agreement to buy or sell a specific amount of an asset at a specific price on a specific future date. Whereas an option gives the holder the right to buy or sell an asset, futures are an obligation.

A few key terms in futures: Tick Size: Minimum price fluctuation of contract; Contract Size: Quantity of asset in one contract; Notional Value: Contract Size * Underlying Asset Price; Delivery: Either financially settled (with cash) or physically settled (goods delivered)

When and why are they used? Futures have two key use cases: Hedging, Speculation. Let’s use simple examples to look at each of them.

First, hedging. Imagine you are a rice farmer. You sell your rice to Happy Fish Sushi, a chain of sushi restaurants. If rice prices rise, that is good for you, but bad for Happy Fish. If prices fall, the opposite is true.

Both you and Happy Fish want to plan your business and limit your exposure to movements in the price of rice. So you make an agreement. You will sell (and they will buy) a set amount of rice at a fixed price on the 1st day of the month. This is a futures contract!

Now, whether the price of rice rises or falls, you know how much you will be selling your rice for and Happy Fish knows how much they will be buying their rice for. This is a simple example of how futures may be used to allow businesses to hedge – i.e. limit – risk.

Next, speculation. Another very simple example. Say I am bullish on gold prices. I think the price should be $2,000+ per ounce, but see the September futures contract is at $1,500. I buy one contract. September arrives and the price of gold is $2,500, just as I predicted.

My futures contract obliges me to buy at $1,500 per ounce, but I can sell at $2,500 per ounce. I can either (a) take delivery of the gold and sell it or (b) sell the futures contract to someone who will. I used futures to speculate on a price movement (and profited from it).

Highly-traded futures markets include commodities, stock indexes, currencies, interest rates, and precious metals. Trading in futures typically requires a margin account, which entails real risks.

So those are the basics on futures – Futures 101. Stay tuned for more as we dive deeper on this and other topics.