This is part 2 of the 3 part series on Futures. Read part 1 here
In the futures market there are contracts, buyers, and sellers. The contract has an agreed upon price and the action of exchanging the goods for the cash happens at some agreed upon point in the future. Farmer Brown has a wheat crop that will be ready to harvest in 3 months. He knows it will be his best crop yet. He decides to enter a futures contract for his crop with a bread making company called BB Bread. He is the seller of the contract and BB Bread is the buyer of the contract.
Farmer Brown agrees to sell his spring crop for $10 a bushel for delivery in August. At the time that Farmer Brown and BB Bread agree upon the contract, they do not exchange any cash upfront. BB Bread deposits a good faith cash deposit with his broker so they can enter into the contract.
In August, the hail destroys some crops, including Pa’s crop, but not Farmer Brown’s, and the market price for the scarce wheat is sky high, $50 dollars a bushel! Fortunately for BB Bread, they locked in their $10 dollar a bushel price in May.
BB Bread pays the agreed upon $10 a bushel and Farmer Brown delivers the wheat. These days, most traders that enter into futures contracts don’t really have a place to store 100 bushels of wheat, nor do they have the desire to take delivery.
In Part 3, we’ll focus on futures in today’s market.
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