What Is a Futures Contract?
A futures contract is a standardized, exchange-traded legal agreement to buy or sell a specified quantity and quality of an underlying asset at a predetermined price on a specified future date. The buyer agrees to take delivery and the seller to make delivery at contract expiration unless the position is closed or cash-settled earlier. Underlyings include commodities (oil, wheat), financial instruments (Treasury bonds), and financial indices (S&P 500).
Key Characteristics
– Standardized terms: contract size, delivery months, grade/quality, and notional value are set by the exchange.
– Exchange-traded and cleared: a clearinghouse interposes between buyers and sellers, reducing counterparty risk.
– Marked-to-market: profits and losses are settled daily through margin accounts.
– Uses: hedging and speculation.
(Source: Investopedia; regulatory: CFTC)
Key Takeaways
– Futures let participants lock in a future price for an asset or speculate on its price moves.
– They differ from forwards by being standardized, exchange-traded, and centrally cleared.
– Market participants include hedgers (producers, consumers) and speculators (traders, funds).
– Important mechanics: contract specs, initial/maintenance margin, daily settlement, and expiration/delivery rules.
Diving Deep Into Futures Contracts
How futures are priced
A futures price is influenced by the current spot price plus carrying costs (storage, insurance), interest rates (cost of capital), expected dividends (for equities), and any convenience yield (non-financial benefit of holding the physical asset). For financial futures the basic model is:
F = S * e^{(r – y)T} (intuitive form: spot adjusted for financing costs and yields),
where S = spot price, r = risk-free rate, y = dividend yield or convenience yield, and T = time to maturity.
Daily life of a futures position
– Initial margin: deposit required to open a position.
– Mark-to-market: at the end of each trading day gains/losses are credited/debited to margin account.
– Maintenance margin: minimum account balance; if breached, a margin call requires topping up.
– Expiration: either cash settlement or physical delivery depending on contract; many traders close positions before expiration to avoid delivery.
Practical Uses of Futures Contracts
Hedgers
– Producers (e.g., farmers, oil producers) lock in prices to secure future cash flows and reduce revenue volatility.
Example: An oil producer expects to produce 1,000,000 barrels in 12 months. If one CME crude oil futures contract = 1,000 barrels, the producer would sell 1,000 contracts to hedge volume risk. If the one‑year futures price is $78/bbl, selling 1,000 contracts locks in $78 million revenue (ignoring basis and transaction costs).
– Consumers (e.g., airlines, manufacturers) buy futures to fix input costs.
Speculators
– Traders and funds take directional risk to profit from price swings. They use leverage (margins) to amplify returns (and losses).
– Common strategies: directional trades (long/short), spread trades (calendar, inter-commodity), and volatility plays.
Exploring Different Types of Futures Contracts
– Commodity futures: crude oil, natural gas, gold, agricultural products.
– Financial futures: interest rates (Treasury), currency futures, stock index futures (S&P 500).
– Contract varieties: full-size, mini, and micro contracts (smaller ticket sizes suitable for retail).
Futures Contract vs. Forward Contract
– Futures: standardized, exchange-traded, cleared, marked-to-market daily.
– Forwards: OTC, customizable terms, bilateral counterparty risk, typically settled at maturity.
– Practical implication: futures are more liquid and regulated; forwards are flexible and used for bespoke exposures.
How Futures Contracts Work — Example Workflow
1. Select market and contract month.
2. Determine exposure and contract size. Use: number of contracts = exposure / contract size.
Example: Want to hedge 100,000 barrels of oil, contract = 1,000 barrels → 100 contracts.
3. Open account with a futures-clearing broker and fund margin.
4. Place order (buy to go long, sell to go short).
5. Track account for daily margin variation (mark-to-market).
6. Close position prior to expiration to avoid delivery (or follow delivery/cash-settlement rules if you want to deliver/receive).
The Process of Trading Futures Contracts
– Choose an exchange and contract: CME, ICE, etc.; study contract specs (size, tick value, trading hours, last trading day, delivery specifics).
– Open and fund a futures trading account with a regulated broker capable of futures clearing.
– Understand margin requirements: initial margin, maintenance margin, and how margin calls are handled.
– Use risk controls: position limits, stop-losses, and proper sizing.
– Close or roll positions: to maintain exposure beyond contract expiry, sell the near-month and buy a further month (roll).
How to Trade Futures Contracts — Practical Steps (Retail Perspective)
1. Education and plan
– Learn contract specs, margin mechanics, and risk management.
– Decide strategy: hedging, short-term directional, spreads, or algorithmic.
2. Choose the right broker and platform
– Look for competitive margin, good execution, robust platform, and regulatory standing.
3. Start with small size
– Use micro/mini contracts if available to limit capital tied up and limit dollar volatility.
4. Risk management
– Size positions as a percentage of equity. Set stop losses and max loss per trade. Monitor margin to avoid forced liquidation.
5. Execution
– Use limit orders for price control; market orders for certainty of execution but potentially worse price.
6. Monitor and adjust
– Track positions, margin, news, and macro variables. Roll contracts before expiration if you want to maintain continuous exposure.
7. Closing vs. delivery
– Most retail traders close before expiration. If holding into expiration, know whether contract is physically delivered or cash-settled and meet any delivery/receipt obligations.
Why Is It Called a Futures Contract?
Because it binds counterparties to trade an asset at a price agreed today for delivery and settlement at a future date. The name reflects that the transaction’s economic outcome occurs in the future.
Are Futures and Forwards the Same Thing?
No. They perform similar economic functions (lock in future prices) but differ in standardization, trading venue, counterparty risk, and settlement mechanics. Futures are exchange-traded and standardized; forwards are OTC and customizable.
What Happens If a Futures Contract Is Held Until It Expires?
– If the contract is physically settled and you hold a short position you may be required to deliver the underlying asset; a long position may be required to take delivery. Exchanges publish delivery procedures and last trading days.
– Many contracts are cash-settled (e.g., index futures) and settle to a cash amount equal to the difference between contract price and settlement price.
– Most speculators close positions before expiration to avoid the administrative and capital implications of delivery.
Who Uses Futures Contracts?
– Hedgers: producers, commercial consumers, financial institutions wanting to lock prices or rates.
– Speculators: hedge funds, proprietary traders, retail traders seeking profit from price movements.
– Arbitrageurs: capture price discrepancies across markets.
– Portfolio managers: use futures to gain/hedge market exposure efficiently.
How Can I Trade Futures?
– Through a registered futures commission merchant (broker) offering access to the exchange.
– Alternatives to direct futures exposure: ETFs/ETNs that track futures (note roll costs), options on futures, and managed futures funds.
– Check requirements: margin rules, minimum account size, and whether micro contracts are offered for lower capital needs.
Practical Examples and Quick Calculations
1. Hedger contract count
– Exposure (units) / Contract size = Number of contracts
– Example: 1,000,000 barrels / 1,000 barrels per contract = 1,000 contracts.
2. Simple profit/loss with margin
– Suppose you buy 1 oil futures contract (1,000 bbl) at $55 and later close at $60: P/L = (60 – 55) * 1,000 = $5,000 gain. This is settled through daily mark-to-market and reflected in your margin account.
3. Rolling a position
– To maintain exposure beyond expiry, sell near-month futures and buy further-month futures; net cost/credit depends on calendar spread.
Risks and Considerations
– Leverage magnifies gains and losses; small price moves can lead to large P/L relative to capital.
– Basis risk: futures and spot prices don’t always move 1:1. Hedging may leave residual risk.
– Margin calls and forced liquidation in volatile markets.
– Delivery obligations if positions are held to expiration for physically settled contracts.
– Regulatory and tax considerations—consult tax/legal advisors for specific rules.
Regulation and Protections
– Futures markets in the U.S. are regulated by the Commodity Futures Trading Commission (CFTC) and self-regulatory organizations like the National Futures Association (NFA). Clearinghouses reduce counterparty default risk.
The Bottom Line
Futures contracts are standardized tools for locking in prices or gaining leveraged exposure to asset prices. They are essential for commercial hedging, price discovery, and speculative strategies. Their exchange-traded, cleared structure makes them liquid and systemically safer than bilateral forwards, but leverage and margin mechanics require disciplined risk management. Retail traders can access futures through regulated brokers and often prefer mini/micro contracts and robust position sizing and stop-loss rules to manage risk.
Sources
– Investopedia — “Futures Contract” (https://www.investopedia.com/terms/f/futurescontract.asp)
– U.S. Commodity Futures Trading Commission (CFTC) — educational resources (www.cftc.gov)
– Exchange contract specifications (e.g., CME Group contract specs pages)
If you want, I can:
– Walk through a worked example using real contract specs (e.g., CL crude oil CME contract) showing margin math and P/L.
– Provide a checklist and template for hedging exposure (how to calculate contracts, monitoring calendar spreads, and rolling).