Futures contracts are agreements which are made and can be traded in commodities exchanges. Such an exchange usually takes place when there are two parties present who are willing to buy or sell a certain commodity at a defined future time at a price fixed from before.
The futures contract is a guarantee to the seller that the buyer will buy the commodity at the fixed price at the future date as determined. Such an exchange has certain specified conditions which are mentioned in the futures contract.
There is considerable risk involved for both parties in a futures contract. While the seller has a risk that he or she might be selling the commodity at a price lower than the market price at the future date as fixed, the buyer faces the risk of having to pay higher than market value which has depreciated for the commodity he has bought and has agreed to pay a certain price for in the future date.
Futures contracts are forward contracts by nature since they represent a future transaction at a specified date. Clearing houses have the responsibility to guarantee the transactions while there are overseeing agencies which regulate such transactions.
In such cases hedging is done to reduce the price risk that can occur with futures contracts. Such contracts are used as tools for hedging by commercial enterprises so that the risk of expected sale and purchase of underlying assets is reduced.
There are several advantages which futures contracts can bring about. When price movements are favorable, producers are assured of the greatest return for their produce. It also helps them to protect their losses when the price movements are negative. Premium charges are also not associated with futures contracts.
There are some disadvantages to consider regarding futures contracts. These can be subject to margin calls, can be disadvantageous when the price moves higher than the terms on the contract. Again, options are contracts on underlying futures contracts while futures contracts need a person to take up the obligation to buy or sell the underlying asset at the agreed price and date.
Thus, futures contracts in commodities markets are vital for producers to be assured of a certain price for their produce in uncertain market conditions. The buyers on the other hand, can also stand to gain when the price movements are higher than the terms on futures contracts. Thus, this form of derivatives trading concerns transactions in the commodities market mostly.