Futures
Key Takeaways
- Futures are standardized contracts to buy or sell an asset at a set price on a future date
- Unlike options, both parties are obligated to fulfill the contract
- Used for hedging by producers and speculators seeking leveraged exposure
- Trade on exchanges like the CME with daily settlement and margin requirements
Definition
A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price on a specified future date. Unlike options, where the buyer has a right but not an obligation, both parties in a futures contract are obligated to fulfill the terms at expiration (though most contracts are closed before delivery).
Futures contracts trade on regulated exchanges such as the Chicago Mercantile Exchange (CME) and cover a wide range of underlying assets including commodities (oil, gold, wheat), stock indices (S&P 500, NASDAQ), interest rates (Treasury bonds), and currencies (Forex).
Futures originated in agriculture as a way for farmers to lock in prices for future harvests and for buyers to secure supply. Today, they are essential instruments for risk management across the global financial system, with daily trading volume worth trillions of dollars.
How It Works
Futures trading uses margin — you only need to deposit a fraction (typically 5-15%) of the contract's total value to open a position. This leverage amplifies both gains and losses. Positions are marked to market daily, meaning gains and losses are settled every trading day.
If you go long (buy) a futures contract, you profit when the price rises and lose when it falls. If you go short (sell), the opposite is true. Most futures traders close their positions before the contract's expiration date to avoid physical delivery of the underlying asset.
Futures prices are related to spot (current) prices through the cost-of-carry model: Futures Price ≈ Spot Price × (1 + Risk-Free Rate - Yield)^Time. When futures trade above spot prices, the market is in "contango." When below, it is in "backwardation."
Example
A portfolio manager worried about a market decline buys 10 S&P 500 E-mini futures contracts at 5,000 points. Each E-mini contract represents $50 per point, so the total exposure is 10 × 5,000 × $50 = $2.5 million. The margin requirement is about $60,000 per contract ($600,000 total) — just 24% of the notional value. If the S&P 500 rises to 5,100, the gain is 100 × $50 × 10 = $50,000. If it drops to 4,900, the loss is $50,000. This leverage makes futures powerful but risky.
Why It Matters
Futures markets serve critical economic functions: price discovery (determining fair values for commodities and assets), risk transfer (allowing producers and consumers to hedge price risk), and market efficiency (arbitrage keeps spot and futures prices aligned). Without futures, airlines could not hedge fuel costs, farmers could not lock in crop prices, and investors could not efficiently manage portfolio risk.
For individual investors, futures provide leveraged access to a wide range of markets including commodities, currencies, and indices that may be difficult to access otherwise. However, the leverage involved makes futures inherently risky, and losses can exceed the initial margin deposit.
Advantages
- Provide leveraged exposure requiring only a margin deposit
- Highly liquid markets with tight spreads
- Available on a vast range of underlying assets
- Essential hedging tools for businesses managing price risk
Limitations
- Leverage amplifies losses as well as gains — can lose more than initial deposit
- Daily mark-to-market requires maintaining margin, potential for margin calls
- Complex instruments requiring significant knowledge
- Most individual investors are better served by ETFs for commodity exposure
Frequently Asked Questions
Related Terms
Browse more definitions in the financial terms glossary.