What is a Futures Contract
A futures contract is a legal agreement to buy or sell a particular 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. The buyer of a futures contract is taking on the obligation to buy the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide the underlying asset at the expiration date.
How Do Futures Contracts Work?
Breaking Down the Futures Contract
"Futures contract" and "futures" refer to the same thing. For example, you might hear somebody say they bought oil futures, which means the same thing as an oil futures contract. When someone says "futures contract," they're typically referring to a specific type of future, such as oil, gold, bonds or S&P 500 index futures. The term "futures" is more general, and is often used to refer to the whole market, such as "They're a futures trader."
Example of Futures Contracts
Futures contracts are used by two categories of market participants: hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased, while portfolio managers and traders may also make a bet on the price movements of an underlying asset using futures.
An oil producer needs to sell their oil. They may use futures contracts do it. This way they can lock in a price they will sell at, and then deliver the oil to the buyer when the futures contract expires. Similarly, a manufacturing company may need oil for making widgets. Since they like to plan ahead and always have oil coming in each month, they too may use futures contracts. This way they know in advance the price they will pay for oil (the futures contract price) and they know they will be taking delivery of the oil once the contract expires.
Futures are available on many different types of assets. There are futures contracts on stock exchange indexes, commodities, and currencies.
Mechanics of a Futures Contract
Imagine an oil producer plans to produce one million barrels of oil over the next year. It will be ready for delivery in 12 months.
Assume the current price is $75 per barrel. The producer could produce the oil, and then sell it at the current market prices one year from today.
Given the volatility of oil prices, the market price at that time could be very different than the current price.
If oil producer thinks oil will be higher in one year, they may opt not to lock in a price now. But, if they think $75 is a good price, they could lock-in a guaranteed sale price by entering into a futures contract.
A mathematical model is used to price futures, which takes into account the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields. Assume that the one-year oil futures contracts are priced at $78 per barrel. By entering into this contract, in one year the producer is obligated to deliver one million barrels of oil and is guaranteed to receive $78 million. The $78 price per barrel is received regardless of where spot market prices are at the time.
Contracts are standardized. For example, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. Therefore, if someone wanted to lock in a price (selling or buying) on 100,000 barrels of oil, they would need to buy/sell 100 contracts. To lock in a price on one million barrels of oil/they would need to buy/sell 1,000 contracts.
Trading Futures Contracts
Retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but they may interested in capturing a profit on the price moves of oil.
Futures contracts can be traded purely for profit, as long as the trade is closed before expiration. Many futures contracts expire on the third Friday of the month, but contracts do vary so check the contract specifications of any and all contracts before trading them.
For example, it is January and April contracts are trading at $55. If a trader believes that the price of oil will rise before the contract expires in April, they could buy the contract at $55. This gives them control of 1,000 barrels of oil. They are not required to pay $55,000 ($55 x 1,000 barrels) for this privilege, though. Rather, the broker only requires an initial margin payment, typically of a few thousand dollars for each contract.
The profit or loss of the position fluctuates in the account as the price of the futures contract moves. If the loss gets too big, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin.
The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1000). Alternatively, if the price drops to $50 and they close out the position there, they lose $5,000.