Futures contracts are standardized agreements to buy or sell a specific asset at a predetermined price on a specified future date. These financial instruments play a crucial role in global markets, allowing businesses to manage risk and traders to speculate on price movements. This guide explains the fundamentals of futures contracts and how they function in today's financial landscape.

Key Takeaways

  • Futures contracts are legally binding agreements to buy or sell assets at a future date
  • They're standardized by exchanges with specific contract sizes and delivery dates
  • Futures serve two primary purposes: hedging risk and speculative trading
  • Most futures contracts are settled in cash rather than physical delivery
  • Futures trading requires margin—a fraction of the contract's full value

The Basics of Futures Contracts

A futures contract is a derivative instrument that derives its value from an underlying asset. These contracts are standardized agreements between two parties to buy or sell a specific quantity of an asset at a predetermined price (the futures price) on a specified future date (the delivery date).

Key Components of Futures Contracts

  • Underlying Asset: The commodity, security, or financial instrument the contract is based on
  • Contract Size: The standardized quantity of the underlying asset
  • Futures Price: The price at which the asset will be exchanged on the delivery date
  • Delivery Date: The specified date when the contract expires
  • Settlement Method: Physical delivery or cash settlement

Example: Gold Futures Contract

A standard gold futures contract on the COMEX exchange:

  • Underlying Asset: Gold
  • Contract Size: 100 troy ounces
  • Price Quotation: US dollars and cents per troy ounce
  • Minimum Price Fluctuation: $0.10 per troy ounce ($10 per contract)
  • Contract Months: February, April, June, August, October, December
  • Settlement Method: Physical delivery (though most traders close positions before expiration)

If gold is trading at $2,000 per ounce, one futures contract represents $200,000 worth of gold (100 ounces × $2,000).

Types of Futures Contracts

Futures contracts span a wide range of asset classes, each serving different market participants:

Commodity Futures

These contracts are based on physical commodities and include:

  • Agricultural: Corn, wheat, soybeans, coffee, sugar, cotton
  • Energy: Crude oil, natural gas, gasoline, heating oil
  • Metals: Gold, silver, copper, platinum
  • Livestock: Live cattle, feeder cattle, lean hogs

Financial Futures

These contracts are based on financial instruments and include:

  • Stock Index Futures: S&P 500, Nasdaq-100, Dow Jones
  • Interest Rate Futures: Treasury bonds, Eurodollar
  • Currency Futures: Euro, Japanese yen, British pound

How Futures Markets Work

Standardization and Exchanges

Futures contracts are traded on specialized exchanges that standardize contract terms. Major futures exchanges include:

  • Chicago Mercantile Exchange (CME)
  • Intercontinental Exchange (ICE)
  • Eurex
  • Tokyo Commodity Exchange (TOCOM)
  • Shanghai Futures Exchange (SHFE)

Standardization ensures liquidity and transparency, making it easier for market participants to enter and exit positions.

Margin Requirements

One of the defining features of futures trading is the use of margin—a performance bond that represents a fraction of the contract's full value. This creates leverage, allowing traders to control large positions with relatively small capital.

  • Initial Margin: The amount required to open a futures position
  • Maintenance Margin: The minimum amount that must be maintained in the account
  • Margin Call: A demand for additional funds when account equity falls below maintenance margin

Leverage: A Double-Edged Sword

While leverage amplifies potential profits, it equally magnifies potential losses. A small price movement in the underlying asset can result in significant gains or losses relative to the initial margin. This is why futures trading requires careful risk management.

Mark-to-Market

Futures positions are "marked to market" daily, meaning profits and losses are calculated and settled at the end of each trading day. This process helps manage counterparty risk by ensuring that losses don't accumulate over time.

Futures Mark-to-Market Process
Daily mark-to-market process in futures trading

Primary Uses of Futures Contracts

Hedging

Futures contracts were originally developed to help businesses manage price risk. Hedging involves taking a position in the futures market opposite to an existing position in the physical market:

Hedging Example: Wheat Farmer

A wheat farmer expecting to harvest 5,000 bushels in September is concerned about falling wheat prices. In May, wheat futures for September delivery are trading at $7.50 per bushel.

The farmer sells (shorts) September wheat futures contracts to lock in the current price. If wheat prices fall to $6.50 by harvest time, the farmer's physical wheat will be worth less, but the futures position will generate offsetting profits.

Speculation

Many traders use futures to speculate on price movements without any intention of delivering or taking delivery of the underlying asset. Speculators provide market liquidity and can profit from both rising and falling markets:

  • Long Position: Buying futures to profit from rising prices
  • Short Position: Selling futures to profit from falling prices

Settlement Methods

Physical Delivery

Some futures contracts result in the physical delivery of the underlying asset when held to expiration. However, physical delivery is relatively rare, accounting for less than 2% of all futures contracts.

Cash Settlement

Most futures contracts are cash-settled, meaning the difference between the contract price and the final settlement price is exchanged in cash. This is particularly common for financial futures where physical delivery would be impractical.

Offset (Closing the Position)

The most common way traders exit futures positions is by offsetting—taking an opposite position in the same contract. For example, if you bought (went long) one gold futures contract, you would sell one gold futures contract to close the position.

Futures vs. Other Financial Instruments

Feature Futures Options Stocks Forward Contracts
Obligation Binding obligation Right, not obligation Ownership Binding obligation
Standardization Standardized Standardized Standardized Customized
Trading Venue Exchange Exchange & OTC Exchange Over-the-counter
Counterparty Clearinghouse Clearinghouse (exchange) or counterparty (OTC) Exchange Direct counterparty
Settlement Daily mark-to-market At expiration or sale At sale At maturity
Leverage High Moderate to High Low (unless margin) High

Futures Market Participants

Hedgers

Businesses and producers who use futures to manage price risk:

  • Farmers hedging crop prices
  • Oil producers locking in selling prices
  • Airlines hedging fuel costs
  • International businesses managing currency risk

Speculators

Traders seeking to profit from price movements:

  • Individual traders
  • Proprietary trading firms
  • Hedge funds
  • Commodity trading advisors (CTAs)

Arbitrageurs

Sophisticated traders who exploit price discrepancies between related markets:

  • Cash-futures arbitrage
  • Inter-exchange arbitrage
  • Calendar spread trading

Getting Started with Futures Trading

Requirements

To trade futures, you'll need:

  • A futures brokerage account with a registered Futures Commission Merchant (FCM)
  • Sufficient capital to meet margin requirements
  • Understanding of futures mechanics and risk management
  • Trading plan and strategy

Risk Management

Due to the leveraged nature of futures, risk management is essential:

  • Use stop-loss orders to limit potential losses
  • Size positions appropriately based on account size
  • Understand margin requirements and potential margin calls
  • Consider using options on futures for defined-risk strategies

Important Considerations for Beginners

Futures trading involves substantial risk and is not suitable for all investors. Before trading futures:

  • Thoroughly educate yourself about futures mechanics
  • Start with a paper trading account to practice
  • Begin with micro futures contracts that offer smaller contract sizes
  • Only trade with risk capital you can afford to lose
  • Consider consulting with a financial advisor

Conclusion

Futures contracts are powerful financial instruments that serve essential economic functions. They allow businesses to manage price risk and provide traders with opportunities to profit from market movements. While futures trading involves significant risk due to leverage, understanding the fundamentals outlined in this guide provides a solid foundation for further exploration.

Whether you're interested in futures for hedging business risk or as a trading vehicle, developing a thorough understanding of contract specifications, margin requirements, and risk management principles is essential for navigating these markets successfully.