What Is a Futures Contract?

A futures contract is a standardized agreement between two parties to buy or sell an underlying asset, such as a commodity, currency, or financial instrument, at a predetermined price and date in the future.

How Do Futures Contracts Work?

Futures contracts are standardized, meaning that they have a specified quantity and quality of the underlying asset, a delivery date, and a delivery location. This standardization makes it easy for buyers and sellers to agree on the terms of a contract and to trade it on an organized exchange.

When a trader buys a futures contract, they are agreeing to take delivery of the underlying asset at the contract’s expiration date. Alternatively, they can sell the futures contract before it expires, effectively canceling their obligation to take delivery of the asset.

When a trader sells a futures contract, they are agreeing to deliver the underlying asset at the contract’s expiration date. Alternatively, they can buy back the futures contract before it expires, effectively canceling their obligation to deliver the asset.

Futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX), and their prices are determined by supply and demand in the market. Prices fluctuate based on a variety of factors, including supply and demand for the underlying asset, geopolitical events, and economic indicators.

Futures contracts are traded with leverage, meaning that traders only need to deposit a fraction of the contract’s value as margin to enter into a trade. This can amplify potential gains, but it can also increase the risk of significant losses if the price of the underlying asset moves against the trader’s position.

Futures contracts are often used by businesses to hedge against potential losses from fluctuations in commodity prices or exchange rates, and they are also used by investors and traders to speculate on future price movements and to diversify their portfolios.

Types of Futures Contracts

There are many types of futures contracts, but here are some of the most common ones:

1. Commodity futures: These contracts are based on physical commodities, such as gold, oil, wheat, corn, and livestock. They are used by producers and consumers of these commodities to hedge against price fluctuations.
2. Financial futures: These contracts are based on financial instruments, such as stock indices, interest rates, and currencies. They are used by investors to speculate on price movements in these markets or to hedge against potential losses.
3. Energy futures: These contracts are based on energy commodities, such as crude oil, natural gas, and gasoline. They are used by producers and consumers of these commodities to hedge against price fluctuations.
4. Metal futures: These contracts are based on metals, such as gold, silver, and copper. They are used by producers and consumers of these metals to hedge against price fluctuations.
5. Agricultural futures: These contracts are based on agricultural commodities, such as wheat, corn, soybeans, and livestock. They are used by farmers, processors, and traders to hedge against price fluctuations.
6. Index futures: These contracts are based on stock market indices, such as the S&P 500, Nasdaq, or Dow Jones Industrial Average. They are used by investors to speculate on the direction of the stock market or to hedge against potential losses in their stock portfolios.
7. Currency futures: These contracts are based on currencies, such as the U.S. dollar, Euro, or Japanese yen. They are used by traders and investors to speculate on exchange rate movements or to hedge against currency risk.

These are just a few examples of the many types of futures contracts available for trading. Each contract has its own specifications, including the size of the contract, the underlying asset, the delivery date, and the delivery location.

Examples of Futures Contracts

Here are a few examples of futures contracts:

1. Crude oil futures: These contracts are based on the price of crude oil and are traded on the New York Mercantile Exchange (NYMEX). One contract represents 1,000 barrels of crude oil, and the price is quoted in U.S. dollars per barrel. These contracts are used by oil producers and consumers to hedge against price fluctuations.
2. Gold futures: These contracts are based on the price of gold and are traded on the Chicago Mercantile Exchange (CME). One contract represents 100 troy ounces of gold, and the price is quoted in U.S. dollars per troy ounce. These contracts are used by gold miners and consumers to hedge against price fluctuations.
3. Euro futures: These contracts are based on the exchange rate between the euro and the U.S. dollar and are traded on the CME. One contract represents 125,000 euros, and the price is quoted in U.S. dollars per euro. These contracts are used by traders and investors to speculate on exchange rate movements or to hedge against currency risk.
4. Corn futures: These contracts are based on the price of corn and are traded on the Chicago Board of Trade (CBOT). One contract represents 5,000 bushels of corn, and the price is quoted in U.S. cents per bushel. These contracts are used by farmers and consumers of corn to hedge against price fluctuations.
5. S&P 500 futures: These contracts are based on the performance of the S&P 500 stock market index and are traded on the CME. One contract represents $50 times the value of the index, and the price is quoted in U.S. dollars per index point. These contracts are used by investors to speculate on the direction of the stock market or to hedge against potential losses in their stock portfolios.
6. S&P 500 E-mini futures: The S&P 500 E-mini futures contracts are one of the most popular futures contracts, providing exposure to the S&P 500 index. There are two main types of E-mini contracts: the E-mini Micro and the E-mini Mini. Here’s a brief overview of each:
   1. E-mini Micro: The E-mini Micro is a smaller version of the standard E-mini contract, with a contract size of 1/10th of the size of the standard E-mini. This makes it an affordable option for individual traders and smaller accounts who want to trade the S&P 500 index futures.
   2. E-mini Mini: The E-mini Mini is a smaller version of the standard E-mini contract, with a contract size of 1/5th of the size of the standard E-mini. The E-mini Mini provides a middle ground between the E-mini Micro and the standard E-mini contract, making it a popular choice for traders with larger accounts who still want to trade the S&P 500 index futures with less capital.

Both the E-mini Micro and the E-mini Mini have lower margin requirements compared to the standard E-mini contract, making them attractive to smaller traders or those with limited capital. They also provide greater flexibility for traders who want to trade the S&P 500 index futures with smaller positions or for shorter durations.

Requirements to Trade Futures

In order to trade futures, traders and investors must be approved by a broker. Approval typically requires a minimum portfolio size and proof of experience in the markets. In addition, traders must sign a customer agreement with the broker which outlines the rules and regulations of the trading platform and their responsibilities as a customer.

Differences Between Futures and Stocks

Futures and stocks are two different types of financial instruments. While they share some similarities, they also have some significant differences. Here are some ways in which futures are different from stocks:

1. Contractual nature: A stock represents ownership in a company, while a futures contract represents an agreement to buy or sell an underlying asset at a future date.
2. Timeframe: Stocks are usually bought and held for the long-term, while futures contracts have expiration dates that can range from a few days to several months or more. A continuous futures contract is created by stitching together multiple futures contracts with overlapping expiration dates. This allows traders and investors to view price data for a specific underlying asset over a longer period of time, rather than just the lifespan of a single futures contract.
3. Leverage: Futures contracts typically require a smaller initial investment, or margin, than stocks, which allows traders to control a larger position with less capital. This leverage can amplify both gains and losses.
4. Standardization: Futures contracts are standardized in terms of quantity, quality, and delivery date, which makes them more easily tradable than stocks, which can vary significantly in terms of company, market capitalization, and other factors.
5. Settlement: Stocks settle when a buyer and seller agree on a price and the shares are transferred. Futures contracts settle at the expiration date, either through physical delivery of the underlying asset or through a cash settlement based on the difference between the contract price and the current market price.
6. Purpose: Stocks are primarily used for long-term investing or short-term trading, while futures contracts are used for hedging, speculation, or as a means of gaining exposure to a particular market or commodity.
7. Market access: Futures trading is typically more accessible to institutional investors and professional traders than to individual retail investors. This is due to the higher capital requirements, complex trading strategies, and technical knowledge involved in futures trading.
8. Liquidity: Generally speaking, stocks are more liquid than futures. This means that it’s easier to buy and sell stocks without affecting the price of the security. In contrast, futures are less liquid and can experience wider bid-ask spreads, which can affect trading costs.
9. Options: Stock options are typically based on the underlying stock, which is a specific equity security. Futures options, on the other hand, are based on the underlying futures contract, which represents a specific commodity, financial instrument, or other asset. Additionally, stock options are often traded on stock exchanges, which are different from futures exchanges.
10. Tick values: Futures contracts have a tick value, which is the minimum price increment that the contract can move up or down. Tick values can vary widely depending on the specific futures contract. In contrast, stocks do not have a tick value, but instead trade in penny increments.
11. Trading sessions: Stocks trade on stock exchanges during regular trading hours, typically from 9:30 a.m. to 4:00 p.m. Eastern time, with after-hours trading available for some stocks. Futures trade on exchanges around the world, with trading sessions that can last for up to 24 hours a day.
12. Fees and tax treatments: Trading stocks and futures can involve different fees and tax treatments. For example, commissions for trading futures are typically higher than for stocks due to the higher level of risk involved. In terms of tax treatment, profits from stock trading are subject to capital gains tax, while profits from futures trading can be taxed as either capital gains or ordinary income depending on the holding period and other factors.
13. Risk: Trading futures carries a higher level of risk than trading stocks, as price movements in futures contracts can be much more volatile and unpredictable. This is because futures contracts are more affected by external factors like supply and demand, economic indicators, and geopolitical events.

Overall, futures and stocks are two different types of financial instruments that have different characteristics, risks, and purposes. Traders and investors should carefully consider their goals, risk tolerance, and investment horizon before choosing between them.

Popular Use Cases of Futures Contracts

Futures contracts are widely used by various market participants for different purposes, including hedging against price fluctuations, speculation, and arbitrage. Here are some common use cases for futures contracts:

1. Hedging: One of the primary uses of futures contracts is to hedge against price fluctuations. For example, airlines often use futures contracts to hedge against fuel price volatility, while farmers use futures contracts to hedge against crop price fluctuations.
2. Speculation: Futures contracts also provide an opportunity for speculators to profit from price movements in the underlying asset. Speculators can take long or short positions in futures contracts based on their market outlook and profit from price changes.
3. Arbitrage: Futures contracts also allow for arbitrage opportunities, where traders can profit from price discrepancies between futures contracts and the underlying asset. For example, if the futures price for a commodity is lower than the spot price, traders can buy the futures contract and simultaneously sell the physical commodity to lock in a profit.
4. Portfolio diversification: Futures contracts can also be used to diversify investment portfolios, as they provide exposure to a wide range of asset classes, including commodities, currencies, and indices.
5. Trading: Futures contracts are also widely traded for their liquidity and ability to provide leverage. Traders can use futures contracts to take on leveraged positions, magnifying potential gains or losses.

Overall, futures contracts provide a versatile financial instrument that can be used for a variety of purposes, including hedging against price fluctuations, speculation, arbitrage, portfolio diversification, and trading.

The Bottom Line

It’s important to note that futures trading involves significant risk, as prices can be volatile and losses can exceed the initial margin deposit. Traders should have a solid understanding of the underlying market and should carefully manage their risk through the use of stop-loss orders, position sizing, and other risk management strategies.