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Are futures contracts created out of thin air? Yes.
If you and I agree on something we will both do, that agreement was just created by the two of us saying we would do it. If an agreement can be legally enforced, it is a contract (as a matter of definition.)
So if you go into a futures market on Monday and enter into a contract to sell or buy a stated amount of x ("x" being anything there are futures contracts for), someone else takes the other side, and then those contracts now exist, and they didn't before.
Now, if you are going to fulfill the contract by actually delivering or actually receiving x, then that's another matter. When it's time to do it, you will have to have some of x, if you're going to sell, or enough money to pay for x, if you're going to buy, or it won't happen. What if you don't really want to receive or deliver any x? Do you get stuck for it? No worries, your broker will close you out beforehand if you're not going to go to delivery.
So what happens in between the creation of the contracts and either their closing out or the delivery?
To enter into the contracts in the first place, both the buyer and seller have to put up some cash, called margin, that is enough to cover the expected daily fluctuations in price of the contract. This is because at the end of each trading day, or when you close the position (if you close before the end of the day), your account is marked to market and receives a debit or credit for the actual profit or loss in the market that day. So if you are long x, and the price goes up, you get a cash credit for your profit that day. If it goes down, you get a debit (and you may have to add to your margin, which you have to maintain to keep the position open.) And the people who are short get the reverse.
Why? So that, if you really are going to go to delivery, your final, net cost is locked in at the price of the contract at the moment you entered it. This is because, if you are long (you are contracted to buy), your actual purchase of real x will cost you more if the price has risen, but you will also have gotten these daily credits equal to the price rise, so you effectively only pay the original price (ignoring fees). If price went the other way, your price of actual x will be lower, but you will have been charged every day against the margin in your account, so you will actually end up paying the original amount on a net basis (ignoring fees also.) The opposite applies to shorts (where you are a seller).
The ability to lock in an effective price means that people in the business of buying and selling x can hedge against market price risk, which is something many will make use of.
If you are just a trader in the contracts and don't plan to ever deliver or sell x, then you will eventually close your position by entering an offsetting contract (you will be counted as flat then), and you will have your unhedged profit or loss, which has already hit your account.
So, aside from many details, that's how all this works.
Bob.
When one door closes, another opens.
-- Cervantes, Don Quixote
Trading: Equities, index options and futures/futures options
Posts: 190 since Apr 2010
Thanks Given: 66
Thanks Received: 198
These days trading in futures is dominated by large funds who have no interest in taking delivery. The opposite side of their trades is taken by the commercials. You can see this by looking at the Commitment of Traders Reports issued by the CFTC each week.
