How does buying oil futures work?

Answer 1

"Futures" are just contracts for a delivery of a certain commodity (oil, in this case) for a "future" delivery. If oil prices never changed, then a oil futures contract would be the base price of oil plus some storage cost and administrative fees.

But this would make for some pretty dull trading and, in fact, oil prices do change -- and sometimes they change a LOT. Like all commodiities, the price is a function of the supply of the commodity v. the demand for that commodity. If supplies are short (e.g. OPEC announces it will cut production by 20%), prices will typically go up. If demand goes down (e.g. Big Oil, Inc. announces it can synthesize oil from old AOL disks, thus making oil as accessible as water), prices for the commodity go down.

A trader may buy an oil futures contract (an agreement on a certain amount of oil at a certain point in the future) in the expectation that the price of oil will rise. If it does, the contract may be worth more. Since the trader doesn't pay the full amount of the contract, but only a small percentage, the trader has a great deal of leverage and their profits (and losses) are much greater than had they simply bought oil itself. (You can also SELL the commodity first, planning to buy back the contract later when/if the price goes down -- a process known as "shorting".)

All commodities trading is a "zero-sum game". For every dollar won, someone loses a dollar. Futures trading is a truly excellent way to lose money in a stunningly fast manner. "Futures" are just contracts for a delivery of a certain commodity (oil, in this case) for a "future" delivery. If oil prices never changed, then a oil futures contract would be the base price of oil plus some storage cost and administrative fees.

But this would make for some pretty dull trading and, in fact, oil prices do change -- and sometimes they change a LOT. Like all commodiities, the price is a function of the supply of the commodity v. the demand for that commodity. If supplies are short (e.g. OPEC announces it will cut production by 20%), prices will typically go up. If demand goes down (e.g. Big Oil, Inc. announces it can synthesize oil from old AOL disks, thus making oil as accessible as water), prices for the commodity go down.

A trader may buy an oil futures contract (an agreement on a certain amount of oil at a certain point in the future) in the expectation that the price of oil will rise. If it does, the contract may be worth more. Since the trader doesn't pay the full amount of the contract, but only a small percentage, the trader has a great deal of leverage and their profits (and losses) are much greater than had they simply bought oil itself. (You can also SELL the commodity first, planning to buy back the contract later when/if the price goes down -- a process known as "shorting".)

All commodities trading is a "zero-sum game". For every dollar won, someone loses a dollar. Futures trading is a truly excellent way to lose money in a stunningly fast manner.