A futures contract is a commitment to make or take delivery of a specific quantity of a commodity or other financial obligation at a predetermined place and time in the future. All terms of the contract are standardized and established beforehand, except for the price, which is determined by open outcry in a pit or ring on the exchange trading floor of a commodity exchange. All contracts ultimately are settled either through liquidation (by offsetting purchases or sales) or by the delivery of the actual, underlying physical commodity. Delivery occurs in less than I percent of all contracts traded, however, as futures contracts are used primarily as financial instruments rather than as vehicles for the exchange of physical goods. The latter occurs in cash (also known as spot) markets instead.
Futures markets provide a medium in which persons or companies that are heavily dependent on prices of basic commodities, international exchange rates, or securities markets can reduce their exposure to adverse price swings. Known as hedging, this process can save companies millions of dollars they would otherwise lose in the cash markets when stock prices go down, foreign currencies lose value, and so forth. Other uses of futures markets include speculative investment and establishing a pricing environment for their underlying goods based on anticipated supply and demand.
In contrast to a futures contract, an options contract is the right, but not the obligation, to buy or sell a futures contract at some predetermined price at anytime within a specified time. Therefore, options give traders more flexibility than standard futures, but at an additional price for that luxury. If the holder of an options contract chooses not to exercise her right, she only pays a premium and does not have to complete the transaction. In a futures contract, the holder must either honor the terms of the contract or offset it by arranging a new contract.
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