What is a Futures Contract?

There are two types of futures contracts, those that provide for physical delivery of a particular
commodity and those that call for an eventual cash settlement. The commodity itself is
specifically defined, as is the month when delivery or settlement is to occur. A July futures
contract, for example, provides for delivery or settlement in July.

It should be noted that even in the case of delivery-type futures contracts, very few actually
result in delivery. Not many speculators want to take or make delivery of 5,000 bushels of grain
or 40,000 pounds of pork. Rather, the vast majority of both speculators and hedgers choose to
realize their gains or losses by buying or selling an offsetting futures contract prior to the
delivery date.

Selling a contract that was previously purchased liquidates a futures position in exactly the same
way that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM
stock. Similarly, a futures contract that was initially sold can be liquidated by making an
offsetting purchase. In either case, profit or loss is the difference between the buying price and
the selling price, less transaction expenses.

Cash settlement futures contracts are precisely that, contracts that are settled in cash rather
than by delivery at the time the contract expires. Stock index futures contracts, for example, are
settled in cash on the basis of the index number at the close of the final day of trading. Delivery
of the actual shares of stock that comprise the index would obviously be impractical.

Mechanics of Futures Hedging

Futures contracts can help a grain producer manage price risk by establishing a forward price for their
grain. Upside potential is given up to eliminate downside price risk. A futures contract is a legally
binding agreement. Completing an offsetting transaction (a contract which nullifies the original
contract) most often satisfies futures contracts. Instead of delivering grain to fulfill the contract to a
Chicago Board of Trade (CBOT) delivery point, the obligation is ended by completion of the
offsetting contract. Buying a like contract (same month, same bushels) offsets the contract that was
originally sold. In essence the “sold” contract is bought back.
Pre-harvest selling of your grain with a futures contract can be an excellent price risk management
tool. Harvest time often is when local prices are often at the lowest point. As a grain producer wanting
to lock in a price and you are concerned that prices will later decrease, the selling of a futures contract
will allow you to lock-in the current higher price. Later, when the futures contract is negated “bought
back”, a sale in the local cash market should be made to complete a true hedge. Selling the actual
inventory of grain establishes the price floor. Even if though local prices are low at this point (in this
example), the profit made from “buying the contract back”, is added to the price received at the local
elevator.
Example 1
Spring Time: Sell futures contract at:$3.00
Harvest Time: Buy back futures contract at: $2.30
Gain on futures: $0.70
Sell grain locally at: $2.20