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I perfectly understand short selling when a person borrows items, sells them at high price, waits for price to fall and buys back the goods so he can return them from where he borrowed and hence profiting.

The situation is slightly confusing me in the futures market where I read that there is no borrowing and one must have physical goods. For example, copied from a financial blog:

You enter into a futures contract to sell 100 shares of IBM at $50 a share on April 1 for a total price of $5,000. But then the value of IBM stock drops to $48 a share on March 1. The strategy with going short is to buy the contract back before having to deliver the stock. If you buy the contract back on March 1, then you pay $4,800 for a contract that’s worth $5,000. By predicting that the stock price would go down, you’ve made $200.

I am confused about where the $200 profit actually comes from because there is no borrowing on futures and if a person buys it back he stays with it, how does he profit?

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Futures are a derivative market and are zero-sum (for every long futures contract, there is a short futures contract). Therefore, the $200 profit comes from a $200 loss by the person who held the long side of that contract.

The idea of borrowing may be a red herring. If you sell a future, you don't exactly borrow the underlying (here, IBM shares), but you contractually owe the underlying. The person who buys the future has an obligation to accept the underlying. You can close your position (remove your obligation) before the expiration date by placing an opposite futures trade at the then-current price. The futures market is just a market for these "owe-accept" agreements.

EDIT: The mechanics of how the profitable trader receives money from the losing trader involve a futures clearing house. Margin put up by the traders is effectively used to pay the profit to the "winner".

  • pardon me, who pays the profit and when? – Mangoma Tunes Apr 2 at 12:38
  • @MangomaTunes I will sell you an avocado future for $1. If you accept, I am obligated to give you an avocado one month from now. I have immediately made $1 by short selling the future. In a month, I may have either a profit or a loss depending on how much it costs to buy the avocado I have to give you. Alternatively, I can just buy another avocado future (from you or someone else) to cancel it out at any time within the month. – Tavian Barnes Apr 2 at 19:51
  • @TavianBarnes futures are not "sold" at a price - you enter into an agreement to sell an avocado at a given price in the future, You have made no profit unless the price of avocados is less than $1 at expiration (at which point you'd buy a cheaper avocado and sell it for $1. – D Stanley Apr 4 at 2:15

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