In this article: http://www.investopedia.com/university/futures/futures2.asp?header_alt=g In the chapter "Profit and Losses-Cash Settlement", the author describes that profit and loss are governed by changes in market prices.

I guess I'm confused as to why there would even be profit and loss in a futures market. The way it was explained, I thought the whole point of a futures contract was to guarantee against the effects of volatility. In other words, you'd enter a contract to be fulfilled for a certain quantity of a commodity at a certain price in advance of a specific fixed date.

So for example, a banana producer agrees to sell 100kg of bananas for $5/kg 3 months from today and the buyer agrees to pay $500 at that date.

If all of those factors are fixed, why do the participants gain and lose money as the price changes in the market?

Is the idea that those changes reflect the price you would get if you want to close your contract by transfering it to someone else? But then, why wouldn't you get the price you paid for initially?

If you were to wait until the date of delivery, would you get the price you agreed to initially, unaffected by price movements?

  • Did you read this part-> "Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from a day's trading are deducted or credited to a person's account each day. In the stock market, the capital gains or losses from movements in price aren't realized until the investor decides to sell the stock or cover his or her short position. " Read more: Futures Fundamentals: How The Market Works | Investopedia investopedia.com/university/futures/futures2.asp#ixzz3wb0rPpJy Follow us: Investopedia on Facebook
    – JB King
    Jan 7 '16 at 21:22
  • @JBKing, Yes that's precisely the part that's confusing to me. I don't understand what there is to settle in the first place if the price was agreed upon and guaranteed not to change.
    – JohnDough
    Jan 7 '16 at 21:25
  • @JBKing, Does the settlement part just mean you can decide to close the contract whenver you want to? In that case, what would be the incentive to close the contract for the party who is losing money relative to the price agreed upon initially?
    – JohnDough
    Jan 7 '16 at 21:30

You are correct that the price fixed when the contract is made is set and maybe there are a few institutions that don't actually bother to track the future after they initiate the contract. But most parties likely track the contracts fairly carefully for a number of reasons. The big deal is that while the price the contract is set, and if you did a perfect hedge maybe the value of the contract and the thing you are hedging is then fixed, the value of that futures contract by itself changes and this is important.

The biggest reason is as JB mentions above most futures contracts settle up on a daily basis as the price of the underlying changes. This happens to limit the losses when for large price changes and one party owes a bunch of money on a futures contract and (for that reason or a different one) goes bankrupt. If the other party is using the contract to hedge a sale or asset maybe this risk is minimal but maybe that expected sale doesn't happen or maybe the party is using futures for speculation. There is no way to know built into the contract if a party is really hedging or not so people naturally want to limit this default risk.

There are many other reasons to track profit and loss as well:

  • reporting and taxes
  • Tracking how well the hedge is working if the hedge is "approximate" in some way which it usually is
  • understanding how much risk you are hedging away or how much risk you are adding in the case of speculation
  • Sometimes the hedge is no longer necessary and one wants to sell the contract
  • A clearing corporation usually requires futures contracts to have some margin posted and when certain amounts are exceeded (too much loss by one party) the losing client must put up more margin

There are likely even more reasons as well that I'm missing but hopefully that gives you an idea.

  • 3
    To add to this: often the clearing corporation has guaranteed the fulfillment of the contract. So, if the purchaser of the futures contract doesn't cover it, the loss comes out of the clearing house's pocket. So THEY will want you to "mark to market" so that losses are covered on a regular basis and not just at the delivery date to limit THEIR potential losses.
    – user11599
    Jan 8 '16 at 2:55
  • Yes, definitely. Forward contracts, which are similar, are between two parties but futures almost always have an intermediary. Thanks.
    – rhaskett
    Jan 8 '16 at 4:56

Daily variation margin is paid to reduce counterparty default risk on PnL. It has nothing to do with the volatility that you might or might not be exposed to via holding a speculative or hedging position in futures contracts.

If anything it reduces the actual real volatility of returns streams as random counterparty defaults are much less likely.

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