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Question Headline:

How does an investor make money when entering a Futures Contract?

Question Body:

I am very new to futures and options. I have been watching videos here on Investopedia in order to learn, but have hit a bit of a snag. On the Futures Contract page, the video states at the end, that the Investor takes on both the risks and rewards by creating this contract. If the milk price goes up, the investor breaks even by gaining money from Tim’s Dairy and losing money from Al’s Ice Cream. Again, when the milk price goes down, the Investor loses money with Tim’s Diary and gains money with Al’s Ice Cream. In every situation, the investor breaks even. So why would the investor waste his time? The only one who is seeming to benefit are Tim’s Dairy and Al’s Ice Cream. What am I missing?

Answer:

When entering a futures contract, an investor is not guaranteed to break even. It is very likely that the investor will gain, or lose money in relative terms. The reason behind this is because, a futures contract obligates the people involved to abide by the contract.

For example, let’s say Joe and Dan enter into a futures contract where Joe plans to sell Dan 100 phones one year from now, for $150 per phone. However, in one year the current market price of phones is $100. Dan is obligated to pay the higher price of $150, due to the futures contract. From this particular futures contract, Joe just made a profit of $5,000 in relative terms, an extra $50 per phone.

Futures contracts can be dangerous, due to the lack of flexibility in the contract. The investor must be confident on the agreed upon price, in order receive higher profits in the future.

In general, I do not recommend the typical retail investor use futures contracts within their investment portfolios. Your average retail investor would be better served focusing on having the appropriate asset allocation (mix of stocks, bonds, and cash) based on their goals, time horizon, and cash flow needs.

— Wyatt Swartz

— Contributions by Caitlin Lammers

— 6/8/2017