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Futures contract

Category — Derivatives
By Nikita Bundzen Head of North America Fixed Income Department
Updated January 17, 2025

What is a Futures Contract

A futures contract is an agreement between two parties to buy or sell an underlying asset at a specified future date for a predetermined price. This financial instrument is known as a derivative because its value is derived from the price of the underlying asset. Futures contracts are widely used in the futures trading industry and are essential components of the futures market.

In futures trading, investors can purchase the right to buy or sell the underlying asset at a specified future date for a specified futures price. If an investor buys a futures contract expecting the price of the underlying asset to increase, they aim to profit from the price movement. Conversely, if they sell a futures contract on the underlying asset, they expect to profit from a decrease in its price.

These contracts can be traded on futures exchanges, which provide a regulated marketplace for trading futures. Market participants in the futures markets include speculators, who seek to profit from price changes, and hedgers, who use futures contracts to manage market risk.

/></p> <h2>Futures Contract Explained</h2> <p>Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. In a futures contract, 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.</p> <p>Underlying assets in futures contracts can include physical commodities like crude oil, agricultural commodities, or other financial instruments such as interest rate futures, bond futures, and currency futures. The underlying commodity or financial instrument defines the nature of the futures contract.</p> <p>Futures contracts are standardized to facilitate trading on a futures exchange. This standardization includes details such as the quantity of the underlying asset, the delivery date, and contract specifications. For example, crude oil futures contracts will specify the amount of oil to be delivered and the quality standards. This standardization is crucial for efficient market functioning and helps maintain liquidity in the futures markets.</p> <p>Market participants use futures contracts for hedging or trade speculation. Hedgers use futures to protect against price volatility in the underlying commodity or financial instrument. For example, a farmer might use agricultural commodity futures to lock in a price for their crops. Speculators, on the other hand, trade futures to profit from anticipated price movements in the underlying asset, such as commodity futures prices or stock futures.</p> <p>Futures contracts differ from forward contracts. While both lock in a future price today, forward contracts are traded over-the-counter (OTC) and have customizable terms negotiated between the counterparties. In contrast, futures contracts are standardized and traded on futures exchanges, which reduces credit risk through the involvement of a clearing house.</p> <h2>Types</h2> <ol> <li> <p><strong>Agricultural Futures</strong>. Include futures positions on grain, cotton, lumber, milk, coffee, sugar, and livestock. These were the first futures contracts available and are vital for managing price volatility in agricultural commodities.</p> </li> <li> <p><strong>Energy Futures</strong>. Provide exposure to energy products such as crude oil and natural gas. Crude oil futures are particularly popular for trading futures in the energy sector.</p> </li> <li> <p><strong>Metal Futures</strong>. Trade in industrial metals like gold, steel, and copper. These futures contracts are crucial for investors looking to hedge against or speculate on commodity prices in the metals market.</p> </li> <li> <p><strong>Currency Futures</strong>. Offer exposure to changes in exchange rates and interest rates of different national currencies. These futures trades are essential for managing risks associated with currency fluctuations.</p> </li> <li> <p><strong>Financial Futures</strong>. Include contracts that trade in the future value of securities or indexes, such as S&P 500 and Nasdaq index futures. Also encompass futures for debt products like U.S. Treasury bonds and German Bundesobligation (BOBL) bonds. These contracts are key for speculating on or hedging against financial instrument price movements.</p> </li> </ol> <h2><strong>Who Trades Futures Contracts?</strong></h2> <ol> <li> <p><strong>Hedgers</strong>. Hedgers use futures contracts to manage or mitigate the risk of price volatility in the underlying commodity or financial instrument. For example, a farmer might use agricultural futures to lock in a price for their crops, protecting against the risk of falling commodity prices. Companies that rely on crude oil might use crude oil futures to secure a stable price and avoid the risk of price increases.</p> </li> <li> <p><strong>Speculators</strong>. Speculators trade futures to profit from anticipated price movements in the market price of the underlying assets. They take on higher market risk in hopes of making a profit from changes in futures prices. Speculators might trade various types of futures, including stock futures, commodity futures, and financial futures, to capitalize on price volatility.</p> </li> </ol> <h2>Futures VS. Stocks</h2> <ol> <li> <p><strong>Trading on Exchanges</strong>. Stocks trade on major stock exchanges like Nasdaq® and NYSE. Futures trade on exchanges like the CME Group, ICE, and Cboe. Both types of exchanges operate clearinghouses as counterparty backstops for every trade.</p> </li> <li> <p><strong>Brokerage Accounts</strong>. Investors need to open an account with a broker to place buy or sell orders in both stocks and futures. Futures brokers are often known as futures commission merchants. Different types of orders exist for both stocks and futures.</p> </li> <li> <p><strong>Expiration</strong>. Shares of stock can theoretically be held indefinitely as long as the company remains publicly traded. Futures contracts have a fixed life and expire on a specified date based on contract specifications. Many futures traders close or roll their positions to avoid physical delivery.</p> </li> <li> <p><strong>Margin Usage</strong>. Margin trading in stocks involves borrowing money from a brokerage firm, allowing investors to buy more stock than they could with their funds. Margin in futures is a good-faith deposit called the initial margin requirement, ensuring each party can meet the contract obligations. It varies by product and market volatility, usually 3% to 12% of the contract value.</p> </li> <li> <p><strong>Advantages and Disadvantages</strong>. Futures offer exposure to important commodities, can diversify or hedge a portfolio, and allow speculation on the underlying commodity. However, the heavy leverage can result in significant losses and margin calls if the market moves against the trader. Stocks provide long-term investment opportunities without expiration but can also involve margin calls if prices move unfavorably.</p> </li> </ol> <h2>Mechanics</h2> <ol> <li> <p><strong>Scenario</strong>. An oil producer plans to produce one million barrels of oil over the next year, ready for delivery in 12 months. The current price is $75 per barrel. The producer could sell the oil at current market prices one year from today, but due to price volatility, the future market price could vary significantly.</p> </li> <li> <p><strong>Locking in Price</strong>. If the producer thinks $75 is a good price, they could lock in a guaranteed sale price by entering into a futures contract. This involves commodity futures trading, where the futures trader agrees to deliver the oil at a fixed price in the future.</p> </li> <li> <p><strong>Pricing Model</strong>. Futures prices are determined using a mathematical model that considers the current spot price, risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields. Assume the one-year oil futures contracts are priced at $78 per barrel.</p> </li> <li> <p><strong>Contract Details</strong>. By entering into this futures contract, the producer is obligated to deliver one million barrels of oil in one year and will receive $78 million, regardless of the spot market price at that time. This ensures the producer receives a fixed cash price per barrel.</p> </li> <li> <p><strong>Standardization</strong>. Futures contracts are standardized. For instance, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. To lock in a price on 100,000 barrels of oil, a futures trader would need to buy or sell 100 contracts. For one million barrels, they would need to buy or sell 1,000 contracts.</p> </li> <li> <p><strong>Regulation</strong>. The futures markets are regulated by the Commodity Futures Trading Commission (CFTC), a federal agency created by Congress in 1974. The CFTC ensures the integrity of futures market pricing, prevents abusive trading practices and fraud, and regulates brokerage firms engaged in futures trading.</p> </li> </ol> <h2>Regulations</h2> <ol> <li> <p><strong>Regulatory Body</strong>. All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States government. The CFTC oversees the futures industry to ensure market integrity.</p> </li> <li> <p><strong>Authority</strong>. The CFTC has the authority to impose fines and other punishments on individuals or companies that violate regulations. This includes the power to regulate futures transactions and enforce compliance within the futures industry.</p> </li> <li> <p><strong>Exchange Rules</strong>. Although the CFTC regulates all transactions, each exchange can have its own rules. These exchanges, which handle exchange traded futures, can fine companies for various infractions or extend fines imposed by the CFTC.</p> </li> <li> <p><strong>Reporting Requirements</strong>. The CFTC publishes weekly reports detailing the open interest of market participants for each market segment with more than 20 participants. These reports are released every Friday and include data from the previous Tuesday. The reports categorize open interest into reportable and non-reportable, as well as commercial and non-commercial open interest.</p> </li> <li> <p><strong>Commitments of Traders Report (COTR)</strong>. This report, known as the Commitments of Traders Report (COT-Report or simply COTR), provides transparency in the futures markets by showing the open interest positions held by various market participants. It helps in understanding the distribution of futures positions across different segments.</p> </li> </ol> <h2>Example</h2> <p>A coffee producer enters a futures contract to sell 10,000 pounds of coffee at $1.50 per pound in six months. The producer takes a short futures position in the underlying futures contract, locking in the sale price regardless of future price moves. If the price of coffee drops to $1.30 per pound, the producer benefits from the price difference through cash settlement instead of physical commodity delivery. Futures traders must maintain a margin account to cover potential losses and avoid a margin call. Futures transactions occur during the trading session, with buyers and sellers exchanging contracts that represent the commodity. The CFTC regulates these financial derivatives, ensures the market's integrity and proper handling of performance bonds.</p> </div> <div class=

FAQ

  • How do futures contracts payout?

    Futures contracts payout through either cash settlement or the delivery of the actual commodity. In cash settlement, the difference between the contract price and the market price at expiration is paid out. If the contract calls for physical delivery, the seller delivers the commodity represented by the contract to the buyer. The dollar value of the payout depends on the contract's terms and the commodity's price moves.

  • Are futures better than stocks?

    Whether futures are better than stocks depends on the investor's goals and risk tolerance. Futures contracts allow for higher leverage and can be used for hedging or speculation, offering the potential for significant gains or losses. They also involve maintaining a futures account and performance bond. Stocks, on the other hand, represent ownership in a company and typically involve lower risk and no obligation for physical delivery or cash settlement.

  • Can anyone buy a futures contract?

    Yes, anyone with the necessary trading privileges and a futures account can buy a futures contract. However, they must meet the initial margin requirements and maintain the performance bond. Investors need to understand the risks and mechanics of future contracts, as they differ from forward contracts and involve specific obligations related to the commodity represented.

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