A futures contract is a legally binding agreement to buy or sell a specific commodity, asset, or security at a predetermined price at a specified future date. To facilitate trading on a futures exchange, futures contracts are standardized in terms of quality and quantity.
The buyer of a futures contract commits to buying and receiving the underlying asset when the contract expires. Conversely, the seller is obligated to provide and deliver the underlying asset at the expiration date.
Key Takeaways
- Futures contracts are derivative financial instruments obligating the buyer to purchase or the seller to sell an underlying asset at a predetermined future price and date.
- Investors use futures contracts to speculate on the direction of a security, commodity, or financial instrument, either long or short, by using leverage.
- Futures are also commonly used to hedge against price fluctuations of the underlying asset, mitigating potential losses from unfavorable price movements.
- Tradable futures contracts exist for various commodities, including grains, livestock, energy, currencies, and securities.
- In the United States, the Commodity Futures Trading Commission (CFTC) regulates futures contracts.
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Commodity futures trading on a futures exchange.
Understanding Futures Contracts in Detail
Futures are derivative financial contracts that compel parties to transact an asset at a predetermined future date and price. The buyer must purchase, or the seller must sell, the underlying asset at the agreed-upon price, regardless of the market price at expiration. The underlying asset can be physical commodities or financial instruments. Futures contracts specify the quantity and are standardized for trading on a futures exchange, serving hedging or speculation purposes.
“Futures contract” and “futures” are often used interchangeably. Someone saying they bought “oil futures” means they entered an oil futures contract. “Futures contract” usually refers to a specific type, like oil, gold, bonds, or S&P 500 index futures. Futures contracts also serve as a direct method to invest in oil. The term “futures” is broader, referring to the entire market, as in “They’re a futures trader.”
Unlike forward contracts, futures contracts are standardized. Forwards are similar agreements that lock in a future price but are traded over-the-counter (OTC) with customizable terms negotiated between counterparties. Futures contracts have uniform terms for all participants.
Applications of Futures Contracts
Futures contracts are employed by two primary market participants: hedgers and speculators.
Hedgers: Mitigating Risk
Hedgers, who are either producers or purchasers of an underlying asset, use futures contracts to hedge or guarantee the price at which a commodity is bought or sold. This ensures a buyer and a satisfactory price, shielding them from market fluctuations.
For example, an oil producer might use futures contracts to lock in a selling price and deliver the oil upon contract expiration. Similarly, a manufacturer needing oil can use futures to secure a consistent supply at a predetermined price. 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.
Speculators: Profiting from Price Movements
Speculators, on the other hand, aim to profit from price movements without direct involvement in the underlying commodity. Traders and fund managers use futures to bet on the price of the underlying asset.
For example, a trader expecting a grain price increase might buy grain futures before the delivery date. Unexpected weather changes or growing conditions can cause the futures price to fluctuate, creating profit opportunities.
Types of Futures Contracts Available
Futures contracts exist for various commodities and assets, provided there’s sufficient market demand. Below are some commonly traded futures:
- Agricultural Futures: Originating at exchanges like the Chicago Mercantile Exchange, these include futures for grains, fibers (cotton), lumber, milk, coffee, sugar, and livestock.
- Energy Futures: Offering exposure to common fuels and energy products like crude oil and natural gas.
- Metal Futures: Trading industrial metals such as gold, steel, and copper.
- Currency Futures: Providing exposure to fluctuations in exchange and interest rates between national currencies.
- Financial Futures: Trading the future value of securities or indices, such as futures for the S&P 500 and Nasdaq, and debt products like U.S. Treasury bonds and German Bundesobligation (BOBL) bonds.
Futures Contract vs. Forward Contract
A futures contract resembles a forward contract, where buyer and seller agree on a price and quantity for a product to be delivered later. Both can be used for speculation and hedging.
However, key differences exist. While a futures contract is a standardized agreement traded on an exchange, a forward contract is a private agreement. Although forwards can be traded OTC, they are less regulated and accessible, offering more customization options.
Mechanics of a Futures Contract Explained
Consider an oil producer planning to produce one million barrels of oil in a year, ready for delivery in 12 months. If the current price is $75 per barrel, the producer could sell at market price in a year.
Given price volatility, the future market price might differ significantly. If the producer anticipates higher prices, they might delay locking in a price. However, if $75 is appealing, they could secure a guaranteed sale price via a futures contract.
A mathematical model prices futures, considering the current spot price, risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields. Assume one-year oil futures contracts are priced at $78 per barrel. By entering this contract, the producer is obligated to deliver one million barrels in a year and receive $78 million, regardless of spot market prices.
Contracts are standardized. For instance, one oil contract on the Chicago Mercantile Exchange (CME) represents 1,000 barrels. Locking in a price for 100,000 barrels requires buying or selling 100 contracts, while one million barrels necessitate 1,000 contracts.
The Commodity Futures Trading Commission (CFTC) regulates the futures markets, ensuring pricing integrity, preventing abusive practices and fraud, and regulating brokerage firms involved in futures trading.
Trading Futures Contracts for Profit
Retail traders and portfolio managers are typically not interested in the physical delivery of the underlying asset. Instead, they seek to profit from price movements.
Futures contracts can be traded for profit, provided the trade is closed before expiration. While many expire on the third Friday of the month, contracts vary, so always check specifications.
For instance, if it’s January and April contracts are trading at $55, a trader expecting a price increase could buy the contract at $55, controlling 1,000 barrels. They don’t pay $55,000 upfront but rather an initial margin payment, usually a few thousand dollars per contract.
The position’s profit or loss fluctuates with the futures contract price. If losses become too large, the broker requests more funds, known as maintenance margin.
The final profit or loss is realized when the trade is closed. If the buyer sells at $60, they profit $5,000 [($60-$55) x 1,000]. Conversely, closing the position at $50 results in a $5,000 loss.
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Active trading on a futures exchange floor.
Why Is It Called a Futures Contract?
The name stems from the agreement between buyer and seller on a price today for an asset or security to be delivered in the future.
Are Futures and Forwards the Same Thing?
Both derivative contracts function similarly, but futures are exchange-traded with standardized specifications, while forwards are OTC with customized terms.
What Happens If a Futures Contract Is Held Until It Expires?
Unless closed out before expiration, the short must deliver to the long. Settlement can be in cash, with the trader paying or receiving based on asset price changes. Sometimes, physical delivery is required, making the investor responsible for storage, handling, and insurance.
Who Uses Futures Contracts?
Speculators bet on future prices, hedgers lock in prices to reduce uncertainty, and arbitrageurs exploit mispricings across related markets.
How Can I Trade Futures?
Eligibility depends on your broker and account status. A margin account and approval are required. Qualified U.S. traders can trade on exchanges like the CME, ICE Futures U.S., and CBOE Futures Exchange (CFE).
The Bottom Line
Futures contracts are vital for smooth commodity market operations, allowing buyers and sellers to lock in prices and mitigating daily market fluctuations. Interest rate changes and dividend payments influence futures prices. They provide stability and opportunity for a wide range of market participants.
