What Is a Futures Contract and How Does It Work?
A futures contract is a legally binding agreement to buy or sell a certain commodity, asset, or security at a defined price at a future date. To simplify trading on a futures exchange, futures contracts are standardized for quality and quantity.
When a futures contract is purchased, the buyer assumes the responsibility to purchase and receive the underlying asset when the contract expires. The seller of a futures contract assumes responsibility for providing and delivering the underlying asset at the contract’s expiration date.
Important Points to Remember
- Futures contracts are financial derivatives that bind the buyer to buy (or the seller to sell) an underlying asset at a fixed price and date in the future.
- A futures contract allows an investor to use leverage to bet on the direction of an asset, commodity, or financial instrument.
- Futures are frequently used to hedge the price movement of the underlying asset, thereby reducing the risk of losses due to negative price movements.
What Are Futures Contracts and How Do They Work?
Futures are financial derivatives that bind the parties to trade an item at a fixed price and date in the future. Regardless of the prevailing market price at the expiration date, the buyer or seller must purchase or sell the underlying asset at the predetermined price.
Physical commodities or other financial instruments are examples of underlying assets. Futures contracts specify the quantity of the underlying asset and are standardized to make futures trading easier. Futures can be utilized for trading speculation or hedging.
The terms “futures contract” and “futures” are interchangeable. You might hear someone say they bought oil futures, which is the same as saying they bought an oil futures contract. When someone says “futures contract,” they usually mean a specific sort of future, such oil, gold, bonds, or S&P 500 index futures. One of the most straightforward ways to invest in oil is through futures contracts. “They’re a futures trader,” for example, is a more comprehensive term that is frequently used to refer to the entire market.
Unlike forward contracts, futures contracts are standardized. Forwards are similar to futures contracts in that they lock in a future price in the present, but they are traded over-the-counter (OTC) and feature terms that can be customized by the counterparties. Contracts for futures, on the other hand, will have the same terms regardless of who the counterparty is.
Futures Contracts as an Example
Hedgers and speculators are two types of market participants who employ futures contracts. Producers and buyers of an underlying item can use futures to hedge or guarantee the price at which the commodity is sold or bought, while portfolio managers and traders can use futures to wager on the price changes of an underlying asset.
An oil producer must sell his or her product. They could do it with futures contracts. This allows them to lock in a price for selling the oil and then deliver it to the customer when the futures contract expires. A manufacturing company, for example, may require oil in order to produce widgets. They, too, may employ futures contracts since they like to plan ahead and always have oil coming in each month. This manner, they know in advance what price they will pay for oil (the futures contract price) and when the contract will expire, they will be able to take possession of the oil.
Futures can be purchased on a wide range of assets. Futures contracts are available for stock exchange indices, commodities, and currencies.
A Futures Contract’s Mechanics
Consider an oil company that aims to generate one million barrels of oil in the coming year. In 12 months, it will be ready for delivery. Assume the current price of a barrel is $75. The producer might produce the oil today and sell it one year later at current market pricing.
Given the volatility of oil prices, the market price at the time could be significantly different from what it is now. If an oil producer believes that the price of oil will rise in a year, they may choose not to lock in a price today. However, if they believe $75 is a decent price, they could buy into a futures contract to lock in a guaranteed sale price.
Futures are priced using a mathematical model that considers the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields, among other factors. Assume the price of one-year oil futures contracts is $78 per barrel. By signing this deal, the producer commits to delivering one million barrels of oil in a year and receives a guaranteed payment of $78 million. Regardless of where spot market prices are at the moment, the $78 per barrel price is received.
Contracts are all the same. On the Chicago Mercantile Exchange (CME), for example, one oil contract is for 1,000 barrels of oil. As a result, if someone wanted to lock in a price for 100,000 barrels of oil, they’d have to buy or sell 100 contracts. They’d have to buy/sell 1,000 contracts to lock in a price for a million barrels of oil.
The Commodity Futures Trading Commission oversees the futures markets (CFTC). The Commodity Futures Trading Commission (CFTC) is a federal organization established by Congress in 1974 to safeguard the integrity of futures market pricing, including avoiding abusive trading methods, fraud, and regulating futures brokerage businesses.
What are Futures Contracts and How Do I Trade Them?
Futures Contracts Trading
The underlying asset is not something that retail traders or portfolio managers are interested in delivering or receiving. A retail trader may not require 1,000 barrels of oil, but they may be interested in profiting from oil price fluctuations.
Futures contracts can be exchanged for profit only if the trade is closed before the expiration date. Many futures contracts expire on the third Friday of the month, but contracts vary, therefore read the contract specifications for any and all contracts before trading.
It’s January, for example, and April contracts are selling at $55. A trader could buy the option at $55 if they predict the price of oil will rise before the contract expires in April. They now have ownership of 1,000 barrels of oil. They are not, however, obligated to pay $55,000 ($55 x 1,000 barrels) in exchange for this privilege. Instead, the broker just asks for an initial margin payment, which is usually a few thousand dollars per transaction.
As the price of the futures contract swings, the profit or loss of the position fluctuates in the account. If the loss becomes too large, the broker will request that the trader deposit additional funds to offset the loss. This is referred to as the maintenance margin.
When the deal is closed, the final profit or loss of the trade is realized. If the buyer sells the contract for $60, they will profit $5,000 [(60-$55) x 1,000]. Alternatively, they will lose $5,000 if the price falls to $50 and they close out the investment there.
What Is a Futures Contract and Why Is It Called That?
The name “futures contract” comes from the fact that the buyer and seller of the contract agree on a price today for an asset or security that will be delivered in the future.
Is there a difference between futures and forwards?
The fundamental distinction between these two forms of derivatives contracts is that futures are exchange-traded and have defined contract specifications. These exchanges are tightly regulated and provide clear contract and pricing information. Forwards, on the other hand, are traded over-the-counter (OTC), with terms and contract specifications tailored to the needs of the two parties involved.
What Happens When You Hold a Futures Contract Until It Expires?
The short is bound to deliver to the long, who is compelled to take it, unless the contract position is closed out before it expires. The exchanged values can be settled in cash depending on the deal. Depending on whether the underlying asset gained or dropped throughout the investment holding period, the trader will often pay or receive a cash settlement. Futures contracts, on the other hand, may necessitate physical delivery in specific instances. In this case, the investor who holds the contract until it expires is responsible for storing the products and must cover material handling, physical storage, and insurance charges.
Futures Contracts: Who Uses Them?
Speculators can speculate on the future price of an asset or security using futures contracts. Hedgers utilize futures to lock in a price today in order to limit market uncertainty between now and the delivery or receipt of the good. Arbitrageurs trade futures contracts in or across connected markets, attempting to profit from temporary theoretical mispricings.
How do I go about trading futures?
You may be able to trade futures depending on your broker and your account status with that broker. You’ll need to apply for and be accepted for a margin account. Qualified traders in the United States will frequently be able to trade futures on exchanges such as the Chicago Mercantile Exchange (CME), ICE Futures United States (Intercontinental Exchange), and the CBOE Futures Exchange (CFE).