Futures are traded in organized futures exchanges (also called futures markets). Futures exchanges are electronic exchange markets where producers and consumers of different commodities make future contracts. Mostly, it is used to hedge the risk from the price exchanges. It is also used by speculators who wants to make profit from the price changes.
The Mechanics of Futures Trading
In futures the contract is make today but the delivery of asset and payment is to be made at one time in the future. However, the buyer have to put up margin in the form of cash or treasury bills. And, futures are marked to market. This means that each day any profits or losses on the contract are credited or debited into your account.
For example, suppose in January your company buys one million gallons of oil in August futures contract in a futures exchange for a future price of $1.5 per gallon and put up a margin of $100,000 in your futures exchange account. The next day the price of the August contract decrease to $1.475 per gallon, now your account is
100,000 – 0.025(100,000) = $97,500 ($2,500 are debited from your account)
Now, suppose the next day the price of the August contract increase to $1.485 per gallon, your futures exchange account is now
97,500 + 0.01(97,500) = $98,475 ($975 are credited into your account)
Futures exchanges not only assures that the contract will be honoured but also set up daily profit or loss account. Hence, futures exchange effectively eliminates counter party risk.