Wikipedia says: “A Futures Market” is an exchange for financial contracts. What exactly is a Futures Contract then? The Futures Contract, also known as a Futures Contract or Futures Contract Agreement is an agreement between two parties to purchase specified commodities and financial instruments for a set price at some future time. Read more?
Contract should be highlighted. It is important to note that there are some differences between trading contracts on the Futures Market versus, for example, stock shares. The company shares (or pieces) are never bought or sold. Futures Contracts allow investors to agree on a certain quantity of an asset or financial instrument.
The workings of commodities are fairly straightforward. A company, such as an airline, may agree to buy 100,000 gallons (or more) of fuel at market value, but not receive the product until later.
Southwest Airlines had made money even when fuel cost $140/barrel, but other airlines did not. The oil price was lower when they negotiated Futures Contracts. Delivery wasn’t until 2007/2008. Then, when the oil price is low again they will purchase Futures Contracts to be delivered in 2011/2012.
It’s good to have a strategy, but it isn’t really trading.
Each Futures Contract has a level of risk. Futures Contracts reduce risk by leveraging it against the underlying asset’s value.
Southwest took on risk. They paid extra if crude oil prices fell below their contract price. Simultaneously they minimized risk, as they assumed that the oil price would be higher than contract price. The leverage in this case was beneficial.
Take a look at oil companies. Because they believed crude oil would drop below the contract prices with Southwest, they reduced their risks. Because the oil price rose above the contract, they acquired additional risk. The leverage they had was not quite as strong as it should have been.