What Are Future Contracts?

For me, and perhaps for others, the leap from forward contracts to derivatives like futures feels like wading into murky waters. The idea of "cattle futures" sounds abstract, especially when compared to a tangible, "Here's a Hereford white face cow for you to buy." 

But, perhaps you'll be surprised to learn that you've probably already navigated the realm of futures contracts in your daily life.

Imagine planning a vacation six months ahead. Maybe you're targeting a tourist hotspot like Orlando or visiting family in cities with fluctuating hotel availability, like Waco, Lubbock or College Station during football season. You anticipate that as your travel date nears, finding an available room at a reasonable rate might be challenging. To mitigate this, you engage in a simple, effective and well-known risk management practice.  You reserve a hotel room well in advance.

Envision doing it the traditional way—calling the hotel directly (we'll dive into platforms like Booking.com later). With a reservation, the hotel guarantees your room for a future date based on today's price, even though the stay is months away. You've effectively secured an asset at today's rate, typically without a binding obligation until shortly before your stay.

At its core, this is a futures contract. You've hedged against potential price hikes and ensured the asset's availability for when you need it.  (Noted that reservations are usually free, while commodity futures contracts are not).

Now, here's where the hotel booking analogy becomes even more intriguing in relation to commodity futures contracts. Futures contracts seldom result in the physical delivery of the commodity by the specified date. More often than not, these positions are closed prior to delivery.

Let's add a twist to our hotel scenario. Imagine you're unsure which city to visit—Orlando, Branson, or New Orleans—so you've booked rooms in all three. Suppose you can also transfer your reservations to others, profiting if sold at a higher price. This scenario closely mirrors futures contract trading. As the vacation nears, and your situation becomes clearer, you decide on a single destination, "taking physical delivery" of one room, while selling off the others—hopefully at a profit, but potentially at a loss. This dynamic captures the essence of futures contract trading.

In upcoming articles, we'll delve deeper into this analogy by exploring options. Through this perspective of viewing hotel bookings as a derivative, you'll soon discover that you're more familiar with futures and options than you ever realized!