Oil futures are financial instruments that represent an agreement to buy or sell a specific amount of crude on a particular date at a specific price. Oil futures are among the most traded futures contracts. Light sweet crude is the most preferred derivative for futures trading. However, other variants of crude oil are also traded globally.
Understanding Oil Futures
Buying oil futures does not mean that an investor has to buy physical crude oil barrels. In fact, the very idea of not owning physical oil makes the oil futures market work. Oil futures are typically purchases by either hedgers or speculators. Those interested in buying and selling physical oil are called hedgers. Hedges are keen to minimize the risk associated with potential fluctuations in crude oil prices. Speculators are common investors who wish to invest in the futures market to make a profit. They buy and sell futures to gain exposure to the oil market and have no interest in purchasing oil as a commodity.
Oil futures can be purchased short or long. Speculators who buy short hedge futures benefit from declines in oil prices, whereas the buyers of long hedge oil futures make profits when prices surge.
Hedgers would usually trade simultaneously in the oil futures market and the spot market. The spot market is the cash market that considers the daily pricing of oil. By taking an opposite position in the cash market from what they speculated in the futures market, hedgers protect themselves against high fluctuations in oil prices.
How Oil Futures are Traded
Like any other futures contract, oil futures are also highly standardized in term of maturity date, quantity and quality. Both the buyer and the seller are legally obliged to fulfill the terms of the contract on the mentioned date.
Futures contracts are standardized and traded through futures exchanges. They define the underlying cost of oil futures based on predictions and historical analysis. Trading can take place through electronic systems or public outcry. The New York Mercantile Exchange (NYMEX) in the United States is the preferred venue for trading oil futures. International Petroleum Exchange is the major trading center in the UK.