What is a Futures Contract?
A futures contract is a legally binding agreement to buy or sell an asset, such as a commodity or financial instrument, at a predetermined price on a specified future date. These contracts are standardized in terms of quality and quantity to enable smooth trading on a futures exchange.
The buyer of a futures contract agrees to purchase and receive the underlying asset when the contract expires. Conversely, the seller agrees to provide and deliver the underlying asset at the expiration date.
Key Takeaways
- Futures contracts are financial derivatives that commit the buyer to purchase and the seller to sell a specific asset at a set future date and price.
- These contracts allow investors to speculate on price movements and hedge against potential price fluctuations.
- Widely traded futures contracts cover commodities such as grain, livestock, energy, currencies, and securities.
- Futures contracts in the United States are regulated by the Commodity Futures Trading Commission (CFTC).
Understanding Futures Contracts
Futures contracts obligate the involved parties to transact an asset at a specified future date and price. Regardless of the current market price at the expiration date, the buyer must purchase, and the seller must sell, the underlying asset.
Underlying assets range from physical commodities to financial instruments. These contracts are standardized to facilitate smooth trading on futures exchanges.
The term ‘futures’ is commonly used to refer to the entire market, such as oil, gold, bonds, or stock index futures, and not just individual contracts. Unlike forward contracts which are customizable and traded over-the-counter (OTC), futures are standardized and traded on regulated exchanges.
Application of Future Contracts
Futures contracts are mainly used by two groups of market participants: hedgers and speculators.
Hedgers
Producers or buyers of an underlying asset use futures contracts to lock in prices, mitigating the risk of price fluctuations. For example, an oil producer may lock in the selling price of oil by entering into a futures contract, ensuring profitable deals despite market volatility.
Speculators
Many traders use futures contracts to speculate on price movements. For instance, a trader might purchase grain futures with the expectation that its price will rise. Any unforeseen changes like weather conditions affecting the crop yield may cause the futures price to increase or decrease.
Types of Futures Contracts
- Agricultural Futures: Tradable contracts in grains, fibers (like cotton), lumber, milk, coffee, sugar, and livestock.
- Energy Futures: Contracts for crude oil, natural gas, and other fuels.
- Metal Futures: Trade in industrial metals like gold, steel, and copper.
- Currency Futures: Exposure to foreign exchange rates and interest rates.
- Financial Futures: Includes futures for financial indexes like the S&P 500 and U.S. Treasury bonds.
Futures vs. Forwards Contracts
While similar, futures contracts are standardized and exchange-traded, unlike forwards which are private agreements with customizable terms. Futures provide greater market accessibility and stringent regulation, benefitting retail investors.
Mechanics of a Futures Contract
Consider an oil producer planning to produce one million barrels of oil in the next year, currently priced at $75 per barrel. They may prefer to lock in a price using a futures contract, securing a predetermined sale price irrespective of future market volatility.
For example, if one-year futures contracts are priced at $78 per barrel, the producer, through a futures contract, ensures selling the oil at this rate, totaling $78 million, despite future spot prices. Futures contracts on the Chicago Mercantile Exchange (CME) are standardized, often covering specific quantities such as 1,000 barrels of oil per contract.
Trading Futures Contracts
Retail traders and fund managers often trade futures for profit rather than receiving the actual commodity, closing out positions before expiration to realize gains. For example, purchasing a contract at $55 in January and selling it at $60 before April would yield a $5,000 profit per contract.
How to Trade Futures Contracts
Your broker and account status determine eligibility for trading futures. You’ll need a margin account and approval. Traders in the U.S. typically trade futures on platforms like the CME, ICE Futures U.S., and the CBOE Futures Exchange.
The Bottom Line
Futures contracts facilitate effective risk management and speculative opportunities in diverse markets. They enable producers, manufacturers, and traders to hedge against price volatility, ensuring stability and profitability in their operations.
Related Terms: forward contracts, derivatives, speculation, hedging, commodity futures, financial futures.
References
- CFTC. “The Commission”.
- CFTC. “Futures Contract”.
- CME Group. “Understanding the Role of Hedgers”.
- CME Group. “Understanding the Role of Speculators”.
- Charles Schwab. “Understanding Futures”.
- CME Group. “Crude Oil Futures - Contract Specs”.
