A futures contract is a legal agreement to buy or sell a commodity or asset 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. They were originally developed to allow farmers to hedge against changes in the prices of crops to reduce risk, but are now commonly used for commodities, currencies, shares, bonds and other financial instruments.

Introduction to Futures Contracts

Futures contracts enable buyers and sellers to lock in the price today for a transaction that will take place in the future. It helps producers and consumers hedge against price volatility. For example, a wheat farmer can enter a futures contract to sell wheat at a specified price and date to protect against falling wheat prices at harvest time. Meanwhile, a bread producer can enter a futures contract to buy wheat at a specified price and date to protect against rising wheat prices.

The futures contract has standardized terms that define the underlying asset, quantity, delivery location, delivery date and minimum quality. Standardization makes futures contracts easy to trade on an exchange. It also provides liquidity because many market participants are trading the same contract.

Participants in the futures market include hedgers who use futures to manage risk, and speculators who aim to profit from price changes. Futures trading is regulated by the Commodity Futures Trading Commission (CFTC).

Key Features of Futures Contracts

Here are some of the key features of futures contracts:

Standardized Contracts

Futures contracts are standardized in terms of the quantity and minimum quality of the underlying asset. For agricultural commodities, the deliverable quantity is typically specified in pounds or bushels. For financial assets like bonds, the deliverable quantity is a fixed face value like $100,000.

Standardization allows the contracts to be interchangeable. This facilitates liquidity in the futures market as participants can easily take on offsetting positions.

Underlying Assets

Futures contracts are available on a wide variety of underlying assets, including:

  • Commodities – crude oil, natural gas, corn, wheat, gold, silver
  • Currencies – Euro FX, Japanese Yen
  • Bonds – Treasury notes, Treasury bonds
  • Stock market indexes – S&P 500, Dow Jones Industrial Average
  • Interest rates – Fed Funds rate, Eurodollars

New futures contracts continue to be introduced as the market evolves. Cryptocurrency futures have emerged in recent years due to the growth of digital assets.

Delivery Dates

Futures contracts have defined expiration or delivery dates, which is when the contract must be settled. The delivery month and year are part of the contract specification.

For example, the delivery months for corn futures are March, May, July, September and December. Traders can choose the contract month based on when they want to make or take delivery.

Most futures contracts extend out for several delivery months to provide a selection of expiration dates. Some contracts extend out for multiple years. Crude oil futures on the New York Mercantile Exchange (NYMEX) extend out for up to 9 years.

Price Limits

Futures exchanges like the CME Group impose price limits on futures contracts to prevent excessive speculation. If the price rises or falls by the limit amount from the previous day’s settlement price, trading is halted temporarily. Price limits help smooth out dramatic price swings and reduce panic in volatile markets.

Marking to Market

Futures contracts are marked-to-market daily, which means the accounts of buyers and sellers are adjusted to reflect their gains or losses based on the current market price at the end of each trading day. This avoids having to wait until settlement to realize gains and losses.

Clearinghouses

Clearinghouses stand between the buyer and seller to guarantee the terms of the futures contract. They take on counterparty credit risk, meaning futures traders don’t have to worry about the other party defaulting. Two examples of prominent clearinghouses are the Options Clearing Corporation (OCC) and CME Clearing.

How Futures Contracts Work

Here is a step-by-step overview of how futures contracts work:

  1. A futures contract is created on an exchange after agreeing on standardized specifications like quantity, delivery date and location.
  2. A buyer and seller enter into a futures contract. The buyer agrees to purchase an asset at a specific price on a future date. The seller agrees to sell the asset at that price on the specified date.
  3. The buyer posts a good faith deposit called margin to initiate the futures position. This protects against default risk.
  4. As the market price of the underlying asset changes day-to-day, the accounts of the buyer and seller are marked-to-market daily based on the settlement price at the end of each trading session. If the market price rose, the buyer has made a profit while the seller has a loss. If the market price declined, the seller has a profit while the buyer has a loss.
  5. When the futures contract reaches its delivery date, the buyer must take delivery and payment is made to the seller. Most futures positions are closed out before delivery by making an offsetting trade because the objective was to hedge or speculate on price, not take physical possession.
  6. At delivery, the clearinghouse facilitates the transaction. Full payment is made from the buyer’s account to the seller’s account. The clearinghouse takes on counterparty risk.
  7. If delivery occurs, the buyer receives the underlying commodity or financial instrument as specified in the futures contract. The exchange procedures facilitate delivery logistics.

Key Differences Between Futures and Forwards

Futures contracts have some major differences from forward contracts:

  • Standardization – Futures have standardized contract terms while forwards can be customized.
  • Exchange-Traded – Futures trade on regulated exchanges while forwards trade over-the-counter.
  • Mark-to-Market – Futures are mark-to-market daily while forwards are settled at maturity.
  • Counterparty Risk – Futures use a clearinghouse while forwards have bilateral counterparty risk.
  • Liquidity – Futures benefit from greater liquidity than forwards due to standardization and exchange-trading.
  • Initial Margin – Futures require the posting of initial margin while forwards do not.

The exchange-traded nature, liquidity and central counterparty clearing provide key advantages of futures over forwards. However, forwards allow customization for hedgers with specialized needs.

Types of Traders in Futures Markets

There are two primary types of traders that participate in the futures markets – hedgers and speculators:

Hedgers

Hedgers use the futures market to reduce price risk. They take equal and opposite positions in the futures and cash markets. Common hedging strategies include:

  • Short hedge – A producer sells futures to lock in a selling price for their commodity. For example, a corn farmer shorts futures to hedge against falling corn prices.
  • Long hedge – A consumer buys futures to lock in a purchase price. For example, a livestock feeder longs futures to hedge against rising corn prices.
  • Cross hedge – Hedging with a different but related futures contract when a direct hedge is unavailable. For example, using soybean oil futures to hedge sunflower oil.

Speculators

Speculators aim to profit from futures price moves. They assume price risk that hedgers are looking to avoid. Common speculative strategies include:

  • Long – Buying futures in anticipation of prices going up
  • Short – Selling futures in anticipation of prices going down
  • Spread – Simultaneously buying and selling related futures to profit from changes in the price relationship

Speculation provides liquidity to futures markets. However, excessive speculation can increase volatility which disrupts effective hedging. Position limits regulate the number of futures contracts large speculators can hold.

Reading Futures Prices and Quotes

Understanding how to read futures prices, quotes and tickers is essential for monitoring the markets. Here are the key elements:

Prices

Futures prices are quoted as the price per unit of the underlying commodity or financial instrument. For example, gold futures may be quoted in dollars per troy ounce.

Futures prices change throughout the trading day as buyers and sellers place orders. The settlement price is the official daily closing price used to mark contracts to market.

Tickers

A futures ticker includes:

  • Contract – Identifies the futures contract (e.g. CL for Crude Oil)
  • Delivery Month – Expiration month (e.g. Dec for December)
  • Price – Current market price
  • Change – Change from the prior close

For example: CL Dec 50.25 +0.75 means the Crude Oil December contract is quoted at $50.25 per barrel, up $0.75 from the previous close.

Quotes

The bid price is the highest price a buyer is willing to pay. The ask price is the lowest price a seller will accept. The difference between the two is the bid-ask spread.

Futures quotes show the bid and ask. For example:

Soybeans Mar 15 2760 2770

This quote shows the March Soybean futures bid is 2760 and the ask is 2770.

Advantages and Uses of Futures Contracts

Futures contracts offer important benefits:

Price Discovery

Futures prices fluctuate based on the constantly changing dynamics between supply and demand. The live futures market and prices provide valuable information to producers, consumers and investors about trends in commodity markets.

Hedging Risk

The ability to lock in futures prices through a binding contract is key to managing price risk. Futures hedging protects market participants against adverse price moves.

Leverage

Traders can use leverage to control large futures positions with a small amount of margin. Margin requirements are typically 5% to 15% of the contract value. Leverage provides opportunities for enhanced profit potential.

Liquidity

The standardized and exchange-traded structure of futures creates a highly liquid market. Active trading provides tight bid-ask spreads facilitating efficient entries and exits.

Portfolio Diversification

Futures provide portfolio diversification because commodity prices frequently move independent of stocks and bonds. This offers opportunities for additional returns.

Contract Specifications for Major Futures Contracts

Each futures market has its own contract specifications that define key parameters like contract size, minimum tick, trading hours and delivery months. Here are specifications on several major futures contracts:

Crude Oil (CL)

  • Contract Unit: 1,000 barrels (42,000 gallons)
  • Price Quotation: Dollars and cents per barrel
  • Tick Size: $0.01 per barrel ($10 per contract)
  • Trading Hours: 9:00 AM to 2:30 PM ET
  • Delivery Months: All months

Corn (C)

  • Contract Unit: 5,000 bushels
  • Price Quotation: Cents per bushel
  • Tick Size: 0.25 cents per bushel ($12.50 per contract)
  • Trading Hours: 9:30 AM to 1:15 PM CT
  • Delivery Months: March, May, July, September, December

Euro FX (6E)

  • Contract Unit: 125,000 euros
  • Price Quotation: Index points (e.g. 1.3000)
  • Tick Size: 0.00005 index points ($6.25 per contract)
  • Trading Hours: 7:16 PM to 5:00 PM ET
  • Delivery Months: March, June, September, December

Gold (GC)

  • Contract Unit: 100 troy ounces
  • Price Quotation: Dollars and cents per ounce
  • Tick Size: $0.10 per ounce ($10 per contract)
  • Trading Hours: 6:00 PM to 5:00 PM ET
  • Delivery Months: All months

Knowing the contract specifications in detail is essential when actively trading futures contracts in a given market. The exchanges occasionally update specifications when required to maintain orderly futures trading.

Active futures traders employ various strategies in an attempt to profit from price moves:

Trend Following

This involves identifying an upward or downward price trend and taking a corresponding long or short position to ride the momentum in that direction. Technical indicators are used to spot emerging trends and determine entry and exit points.

Spread Trading

This exploits relative value differences between two related futures contracts. For example, simultaneously buying gold futures and selling silver futures if the ratio is moving in favor of gold.

arbitrage

Mispricing between futures for the same commodity across different months or exchanges allows arbitrage profits. The strategy quickly trades the mispricing back into equilibrium.

Fundamental Analysis

This involves analyzing all the fundamental supply and demand factors that impact the physical commodity markets to determine whether futures are overpriced or underpriced. Positions are taken based on the analysis.

Chart Patterns

Traders use technical analysis and identify patterns on price charts, such as head and shoulders or triangles, to signal trend reversals and continuation. Trades are placed when patterns emerge.

Seasonal Trading

Seasonal patterns that tend to repeat each year provide trade opportunities. For example, crude oil tends to bottom in February as the market anticipates increased gasoline demand for summer driving season.

Risks Associated With Futures Trading

While offering substantial upside, futures trading does carry significant risks:

High Leverage

The ability to control large positions with little margin can lead to magnified losses beyond the margin amount if prices move against the futures position.

Liquidity Risk

Though normally liquid, futures markets can rapidly become illiquid after sudden news events. Lack of liquidity makes it difficult to exit positions at a reasonable price.

Gap Risk

Gaps occur when futures open sharply higher or lower outside regular trading hours. Stops intended to limit losses can be gapped through resulting in slippage on the exit.

Contract Expiration

Futures positions held into expiration must be settled in cash or through physical delivery of the underlying. Most traders close out positions prior to expiry to avoid this process.

Electronic Trading

Futures trade exclusively on electronic platforms. System failures and connectivity issues can prevent traders from managing or closing out positions during market ruptures.

Getting Started Trading Futures

Here are some tips for starting to trade futures contracts:

  • Open an account with a reputable futures broker that provides direct market access. Many traders start out using a simulator to practice.
  • Closely analyze contract specifications for the specific futures markets you are interested in trading. Understand contract sizes, tick values and delivery nuances.
  • Start small with 1 contract and use stop-loss orders. Evaluate your risk-reward ratios and performance before increasing position sizes.
  • Develop a trading strategy based on technical or fundamental analysis. Backtest the strategy to evaluate performance.
  • Take advantage of the extensive free educational resources offered online and by brokers to continually improve your knowledge.
  • Be disciplined in following your strategy. Don’t chase trades or deviate from risk management rules.

Conclusion

Futures contracts provide an effective tool for commodity producers, consumers and investors to hedge against risk or capitalize on market opportunities. The futures markets offer liquidity, leverage, and transparency through standardized contracts traded on regulated exchanges like the CME and supervised by the CFTC. However, the inherent risks mean futures trading should be approached prudently with education, practice and robust risk management protocols. Used properly, futures can diversify portfolios and provide potential avenues for significant reward.