If the price of oil keeps going up, should you take the plunge and invest in oil futures? What happens if the price of oil peaks and drops? Is it easy to enter the oil futures market, or would you end up taking a huge loss and sacrificing that early retirement you’ve been dreaming about? Oil futures are an attractive investment, but it’s important to understand the risks before you borrow money in hopes of making a profit later.

What Are Futures, Anyway?

The term futures is slang for commodity futures or futures contracts. When you buy a futures contract, you are in essence locking in the price of a commodity so that you can buy that commodity at a future point and time at the same rate as the day you purchased the right to do so. For example, if you bought a future contract for apples today and apples were selling for a dollar apiece today, you would essentially be buying the right to only pay one dollar per apple for a specified amount of apples on the day you exercised your right, which you would do in the future. If the price of apples doubled a year later, you could then exercise your future contract and buy 100 apples at one dollar apiece. Then, you could sell those hundred apples on the free market at market price (two dollars apiece). In an ideal-world scenario, you could make a profit of a dollar per apple.

What Does It Mean to Buy Oil Futures?

Buying oil futures works in the same way as buying apple futures. You’d buy the rights to buy a set amount of oil (negotiated in units of 1,000 barrels of oil per unit) for a set price-the going rate at the moment of purchase of the oil futures. So, if you bought the futures contract for 1,000 barrels of oil at $150 per barrel, and then the price of oil doubled to $300 per barrel in the future, you could exercise your right to buy that 1,000 barrels of oil and resell it on the free market, making a hefty profit.

But What If You Don’t Want to Buy or Sell Oil?

Legislation surrounding oil futures used to specify that those who bought oil futures had to prove they had the capacity to receive the actual product and resell it. No longer. Now anyone with enough cash can buy the right to buy futures, even if they do not wish to receive the product and sell it.

Instead, investors can buy futures and then turn around and sell those futures to a second party who actually wants to buy and sell the commodity. This is called oil futures trading, since no commodity or product exchanges hands, and you won’t wind up with a barrel of oil in your front yard. Only the right to buy at a certain price is being sold in these kinds of transactions. People who buy futures without the intention of ever actually buying and selling the commodity are called speculators.

Why Are Oil Futures So Popular?

Oil and gold are the two hottest commodities in the futures market for several reasons:

Oil is a limited resource. Once the worldwide supply of oil is used up, it’s gone, making it likely that, in the long run, the prices of oil will continue to rise.

Demand for oil keeps increasing. Demand for oil around the world is increasing because so many countries that used to be rural are modernizing and becoming urban. China and India alone have increased oil consumption by approximately 10% each year for the past several years and show no signs of reversing this trend.

Discovery of significant sources of more oil is unlikely. While there are still untapped sources of oil, it is unlikely that we will discover any new sources of significance.

Since Oil Prices Keep Going Up and Oil is Limited, Why Not Invest in Oil Futures?

Many inherent risks are involved in buying futures, and oil is not immune to any of them.

What if oil prices drop? At some point oil prices will peak and then drop. Just like many investors claimed the housing market bubble would not burst (After all, the population keeps rising, and people need places to live, right?) most trends do indeed end at some point. If you are considering buying oil futures, you need to factor in how much of a loss you could handle financially if the prices did fall, and you should invest within reasonable limits.

What if you can’t sell the futures you bought? If prices drop quickly and dramatically, many investors will be scrambling to sell before the prices fall so low no one wants to buy your futures. Such scenarios quickly snowball into a mad rush to get rid of the very same investments everyone was clamoring for earlier.

Buying oil futures requires a great deal of cash up front. You’ll have to pay for the margins up front, which can be quite costly. Investing in oil futures isn’t for investors who don’t have much to spend, so you’ll need to evaluate if your portfolio can handle the investment.

Only You Can Decide

If you’re willing to take a risk for a potentially lucrative outcome, make sure you check out all the pros and cons of buying oil futures. The Commodities Future Trading Commission is a great place to start for doing research on this popular investment.