A futures contract is a type of derivative that refers to a legal contract and an obligation to buy or sell a particular security at a predetermined price at a specified time in the future. It aims to mitigate the risk faced by investors in the shape of variations in forex exchange rates, bonds, stocks, indexes, and commodities.
What Is a Futures Contract?
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.
The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Understanding Futures Contracts
Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.
Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.
“Futures contract” and “futures” refer to the same thing. For example, you might hear somebody say they bought oil futures, which means the same thing as an oil futures contract. When someone says “futures contract,” they’re typically referring to a specific type of future, such as oil, gold, bonds, or S&P 500 index futures. Futures contracts are also one of the most direct ways to invest in oil. The term “futures” is more general, and is often used to refer to the whole market, such as, “They’re a futures trader.”
Futures contracts are standardized, unlike forward contracts. Forwards are similar types of agreements that lock in a future price in the present, but forwards are traded over-the-counter (OTC) and have customizable terms that are arrived at between the counterparties. Futures contracts, on the other hand, will each have the same terms regardless of who is the counterparty.
Application of a Futures Contracts
Futures contracts are used by two categories of market participants: hedgers and speculators.
Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased. They use futures contracts to ensure that they have a buyer and a satisfactory price, hedging against any changes in the market.
An oil producer needs to sell its oil. They may use futures contracts to lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.
Since many commodity prices tend to move in predictable patterns, it is possible to make a profit by trading futures, even if one does not have a direct interest in the underlying commodity. Traders and fund managers use futures to bet on the price of the underlying asset.
For example, a trader may buy grain futures if they expect the price of grain to increase before the delivery date. Any unexpected changes to the weather or growing conditions may cause the futures price to rise or drop.
Types of Futures Contracts
Futures contracts can be used to set prices on any type of commodity or asset, so long as there is a sufficiently large market for it. Some of the most frequently traded types of futures are outlined below:
- Agricultural Futures: These were the original futures contracts available at markets like the Chicago Mercantile Exchange. In addition to grain futures, there are also tradable futures contracts in fibers (such as cotton), lumber, milk, coffee, sugar, and even livestock.
- Energy Futures: These provide exposure to the most common fuels and energy products, such as crude oil and natural gas.
- Metal Futures: These contracts trade in industrial metals, such as gold, steel, and copper.
- Currency Futures: These contracts provide exposure to changes in the exchange rates and interest rates of different national currencies.
- Financial Futures: Contracts that trade in the future value of a security or index. For example, there are futures for the S&P 500 and Nasdaq indexes. There are also futures for debt products, such as Treasury bonds.1
Futures Contract vs. Forward Contract
A futures contract is similar to a forwards contract, where a buyer and seller agree to set a price and quantity of a product for delivery at a later date. Both types of contracts can be used for speculation, as well as hedging.
However, there are also important differences. While a futures contract is a standardized agreement that can be traded on an exchange, a forward contract is simply a private agreement between a buyer and a seller. While it is possible to trade forwards on OTC markets, they are less regulated and less accessible to retail investors. This means that there are also more opportunities to customize a forward agreement according to the buyer’s and seller’s needs.
Mechanics of a Futures Contract
Imagine an oil producer who plans to produce one million barrels of oil over the next year. It will be ready for delivery in 12 months. Assume the current price is $75 per barrel. The producer could produce the oil, and then sell it at the current market prices one year from today.
Given the volatility of oil prices, the market price at that time could be very different than the current price. If the oil producer thinks oil will be higher in one year, they may opt not to lock in a price now. But, if they think $75 is a good price, they could lock in a guaranteed sale price by entering into a futures contract.
A mathematical model is used to price futures, which takes into account the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields. Assume that the one-year oil futures contracts are priced at $78 per barrel. By entering into this contract, in one year the producer is obligated to deliver one million barrels of oil and is guaranteed to receive $78 million. The $78 price per barrel is received regardless of where spot market prices are at the time.
Contracts are standardized. For example, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil.2 Therefore, if someone wanted to lock in a price (selling or buying) on 100,000 barrels of oil, they would need to buy/sell 100 contracts. To lock in a price on one million barrels of oil/they would need to buy/sell 1,000 contracts.
The futures markets are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC is a federal agency created by Congress in 1974 to ensure the integrity of futures market pricing, including preventing abusive trading practices, and fraud, and regulating brokerage firms engaged in futures trading.3
Trading Futures Contracts
Retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but they may be interested in capturing a profit on the price moves of oil.
Futures contracts can be traded purely for profit, as long as the trade is closed before expiration. Many futures contracts expire on the third Friday of the month, but contracts do vary so check the contract specifications of any and all contracts before trading them.
For example, it is January, and April contracts are trading at $55. If a trader believes that the price of oil will rise before the contract expires in April, they could buy the contract at $55. This gives them control of 1,000 barrels of oil. They are not required to pay $55,000 ($55 x 1,000 barrels) for this privilege, though. Rather, the broker only requires an initial margin payment, typically of a few thousand dollars for each contract.
The profit or loss of the position fluctuates in the account as the price of the futures contract moves. If the loss gets too big, the broker will ask the trader to deposit more money to cover the loss. This is called the maintenance margin.
The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1,000). Alternatively, if the price drops to $50 and they close out the position there, they lose $5,000.
Why Is It Called a Futures Contract?
A futures contract gets its name from the fact that the buyer and seller of the contract are agreeing to a price today for some asset or security that is to be delivered in the future.
Are Futures and Forwards the Same Thing?
These two types of derivatives contract function in much the same way, but the main difference is that futures are exchange-traded and have standardized contract specifications. These exchanges are highly regulated and provide transparent contract and pricing data. Forwards, in contrast, trade over the counter (OTC) with terms and contract specifications customized by the two parties involved.
What Happens If a Futures Contract Is Held Until It Expires?
Unless the contract position is closed out before its expiration, the short is obligated to make delivery to the long, who is obligated to take it. Depending on the contract, the values exchanged can be settled in cash. Most often, the trader will simply pay or receive a cash settlement depending on whether the underlying asset increased or decreased during the investment holding period. In some cases, however, futures contracts will require physical delivery. In this scenario, the investor holding the contract upon expiration would be responsible for storing the goods and would need to cover costs for material handling, physical storage, and insurance.
Who Uses Futures Contracts?
Speculators can use futures contracts to bet on the future price of some asset or security. Hedgers use futures to lock in a price today to reduce market uncertainty between now and the time that the good is to be delivered or received. Arbitrageurs trade futures contracts in or across related markets, taking advantage of theoretical mispricings that may exist temporarily.
How Can I Trade Futures?
Depending on your broker and your account status with that broker, you may be eligible to trade futures. You will require a margin account and be approved to do so. Qualified traders in the U.S. will often have the ability to trade futures on different exchanges such as the Chicago Mercantile Exchange (CME), ICE Futures U.S. (Intercontinental Exchange), and the CBOE Futures Exchange (CFE).
The Bottom Line
Futures contracts play an important role in the smooth operations of the commodities market. By allowing buyers and sellers to lock in prices in advance, they allow farmers, miners, manufacturers, and other market participants to work without having to worry about daily changes in the market.
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