How Futures Work and Why They are Leveraged so Much

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How Futures Work and Why They are Leveraged so Much

By Alex Dixon, YouCanTrade Content Specialist

What are futures? Futures are contracts that lock in future delivery of a commodity or a security at today’s price. In a futures market, participants buy and sell commodity and futures contracts for delivery on a future date- hence the name.

Let’s look at an example:
Take an imaginary large airline company, AirZ, with hundreds of planes flying all around the world every day. AirZ wants to book tickets 6-12 months in advance. AirZ must prepare to maximize profits by allocating the appropriate planes on the appropriate flight paths in the most profitable way they can.  One thing AirZ must determine is how much to charge for flights 12 months out. One of its biggest expenses is jet fuel, derived from oil. Oil can fluctuate in price drastically even in short periods of time.

This is where the futures market comes in. AirZ can buy oil futures contracts for 12 months out and guarantee itself a certain, predetermined price for what it will be able to purchase oil. If the price of oil (and therefore fuel) goes up, the value of its contracts has also increased, offsetting the price of the increased expense. If oil prices drop, it can buy for less than it hedged for and offset the loss it took on the oil futures.

This works the exact same way for oil producers. Oil producers have expenses, infrastructure, payroll and other predictable bills, unlike the product they produce. If they choose, they can sell AirZ some oil contracts 12 months out and prepare ahead for their expenses. If oil prices drop, they benefit since they sold contracts at a higher price and can offset the lower prices with the profits from the futures contracts they sold. If prices rise, the money they lose on the futures contracts will be offset proportionately by the fluctuation of oil.

Why is it leveraged so much? 
In this example, AirZ and the oil producer are not exchanging an actual product, they are exchanging the legal binding promise of executing a transaction in the future, 12 months out. Hedging is a great idea, but at what cost? Is it wise for AirZ to tie up $10 million for something that they will not use for 12 months? AirZ can likely use its capital in other ways, and it will also probably not find it worth it to use that kind of capital for hedging. Same thing with the oil producer, which currently may not even have the oil to deliver.

The futures markets have determined a small percentage of the overall value of the product is all that is needed to control a contract, which will have to be fully exchanged upon delivery. I will use 5% in this example. AirZ now only needs $500,000 to hedge oil prices 12 months from now, which it is much more likely to do.

It works the same way with all futures. Take currency futures, for example. If the producer of 1,000 vehicles is in Japan and the end user is in the United States, the company may want to hedge with the Yen or Dollar futures as the value of the two against each other could drastically change between exchange of the purchase contract for the vehicles and their delivery.

Where do traders come in?

As far as any exchange is concerned, the exchange  is only interested in matching buyers and sellers.  Speculators and traders can come into the market, which increases the sheer volume of buyers and sellers. For the exchange, producers and end users, this creates greater liquidity and gives the general public the opportunity to take advantage of the price movements.

Looking to learn more about futures? Register for the FAST Track Trading Program live course! Learn more.

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