What is a Futures Contract?

While futures trading has gained popularity in recent years, few investors still understand what futures are in trading and how exactly these contracts work. Read on to learn more about buying a futures contract and some investment strategies associated with contract trading. 

What is a Futures Contract?

If you’ve ever used an online bidding site like eBay, it’s easy to see how the haggle's thrill benefits buyers and sellers. Buyers on these websites constantly scan items available for sale, negotiating with buyers through purchasing power for items that are in value. Conversely, sellers look for opportunities to sell their items at a higher price than their value.

If you add a little more structure and risk, you can begin to understand the futures market. The futures market is like a bid site in that buyers and sellers agree on a price for the future delivery of an item, usually a commodity or shares of a financial asset. Unlike a bid site, prices are not individually negotiated between two private parties, but influenced by market forces. 

The basis of the futures market is the futures contract, a tradable asset now available through some brokerages. A futures contract is a financial derivative representing the exchange of a commodity at a specific price at a specific date. Each futures contract has specific details, including the type of asset, contract size (the amount of the asset traded per contract), the price per unit, the contract expiration date and the minimum price movement.

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History of Futures Contracts

While the true genesis of the financial futures market may date back to ancient Babylon, the modern futures market as we know it began to take shape in the mid-19th century in the United States. The Chicago Board of Trade (CBOT) was founded in 1848 to trade agricultural grain commodities such as corn and wheat. The role of the CBOT was to provide regulatory authority for rudimentary futures contracts written between two private parties, an early precursor to today’s Securities Exchange Commission (SEC).  

Following the establishment of multiple other early futures markets in states like New York and Kansas, the market saw regulatory development throughout the early 20th century. This continued until the start of the Great Depression, in which the financial progress of the United States ground to a halt.  

The Commodity Exchange Act of 1936 was introduced as part of a wider set of federal programs to regulate financial markets better and created a single central authority over futures contracts. It also created an oversight board, the Commodity Exchange Authority, which later became the Commodity Futures Trading Commission (CFTC) in 1974.

If the futures market was established to manage agricultural products, what are futures in stocks? Over the years, the futures market expanded beyond agricultural products to include financial instruments such as stock index futures, interest rate futures, and currency futures. These innovations allowed investors and hedgers access to futures trading, often using the same platform they use to buy and sell stocks. 

Types of Futures Contracts 

There are multiple types of futures contracts, each of which are associated with a unique underlying asset.  

• Commodity futures: Perhaps the best-known type of futures contract, commodity futures are based on a tangible underlying product that can be bought and sold. Examples include agricultural products like corn and soybeans, energy resources like crude oil and natural gas and metals like gold and platinum. 
• Financial futures: Financial futures contracts are associated with an underlying financial instrument or asset. Common examples include treasury bonds and stock indexes.  
• Currency futures: These futures contracts involve the exchange of one currency for another at a specified future date and price. Currency futures are commonly used by businesses to hedge against exchange rate fluctuations when dealing with international transactions.

Additional types of futures you might have access to could include interest rate futures, equity futures and even single stock futures. 

How Futures Contracts Work

What is futures trading and how do investors see a profit from these contracts? As the underlying commodities and assets change in value due to market forces, the trading contracts also see changes in value. Investors may purchase a futures contract and sell it at a higher price before the expiration date, the date by which the two parties involved in the contract must either fulfill the contract by exchanging the underlying asset for the agreed-upon price or settling it financially.  

How do futures work? Let’s take a look at a basic example. An investor might perform fundamental analysis on the oil industry and predict that global oil demand will increase. The investor might then purchase a futures contract that binds them to purchase a set amount of oil at the current price in the future. If this prediction turns out to be true and the price of oil does increase, the contract's price will also likely increase. The investor can then sell the contract itself, seeing a profit without the need to execute the contract. 

The Structure of a Futures Contract

Examining futures contract examples, you’ll notice a series of specifications regulating and binding the contract parties. Some factors that play a role in the price of a futures contract include the following.  

• Spot price: The spot price is the current market price at which a specific asset can be bought or sold for immediate delivery and settlement.
• Risk-free rate of return: The risk-free rate of return describes the theoretical interest rate at which an investment can grow with certainty, assuming zero risk of financial loss. It serves as a benchmark for evaluating the potential returns of other investments.
• Time until maturity: If you’ve researched futures, you may have once asked yourself “how long can I hold a futures contract?” The answer will depend on the time until maturity, the remaining period until a financial contract expires. 
• Storage costs: If the contract you’re investing in is associated with an underlying physical commodity like oil or corn, these products must be properly stored. Storage costs associated with the commodity can influence contract cost. 
• Dividend and dividend yields: If you invest in an index future, the underlying asset may produce dividend payments. The dividend yield, which describes the percentage a stock pays out, is baked into the contract's price. 
• Convenience yield: Convenience yields are the benefits or advantages of owning and holding a physical asset, like a commodity, rather than a futures contract on that asset. These benefits can include using the asset for production or consumption, which adds value beyond the futures contract price.

Futures contracts are set at different intervals. In some cases, the price of a futures contract may be set for a year in the future. The important thing to remember is that the price of a futures contract is not set arbitrarily, but rather by market dynamics.

Margin in Futures Contracts

Margin plays a pivotal role in futures trading, serving as a security deposit that traders must maintain to participate. Because futures contracts are usually high-value instruments, brokers require that traders put down only a percentage of the total contract value to trade. This is referred to as “trading on the margin,” with the relative percentage of capital you control being your leverage. 

Terms to Know

After you define futures, it’s important to define all ancillary terms you might encounter while trading. Some examples of essential terms to know include the following. 

• Contract size: The contract size refers to the standardized quantity or volume of the underlying asset specified in a futures contract. It determines the scale of the trade — for example, how many bushels of corn or gallons of oil the contract represents. 
• Contract value: The contract value is the total worth of a futures contract at its current market price, calculated by multiplying the contract size by the prevailing futures price.
• Tick size: Tick size is the minimum price movement or price increment allowed for trading a futures contract.
• Limit move: A limit move refers to the maximum allowable price change, up or down, set by the exchange for a single trading session. When a futures contract reaches its limit, trading may be temporarily halted or restricted to manage extreme price volatility.
• First day notice: The first day notice is the first day on which a seller of a futures contract can notify the buyer of their intention to deliver the underlying asset upon contract expiration physically. This marks the beginning of the delivery process if the contract will fulfilled and not sold before its expiration. 
• Convergence: Convergence refers to the process by which the futures contract price approaches the underlying asset's spot (current market) price as the contract's delivery date approaches. 

Example of Futures Trading

Still not exactly sure of how futures trading works? To help you get a better idea, let’s look at a simplified example of a futures trade using a commodity — oil futures. Imagine that you’re an investor who closely follows the energy market and believes that the oil price will rise shortly. 

In this situation, you might want to open a brokerage account with access to futures trading and open a position that locks in a contract with an underlying quantity of oil at a specific price. Since you’re only looking to profit from the trade and you don’t need to make delivery considerations, your broker will only require you to put down a small percentage of the trade to enter the margin position. From here, you would closely monitor the price of crude oil, with your profits or losses calculated based on how prices change. 

Watching how the price of stocks tied to crude oil like the ProShares Ultra Bloomberg Crude Oil NYSE: UCO can help you gain insights into the crude oil market.  

Once you believe you've made a satisfactory profit or if market conditions change, you can close your futures position by entering an opposite transaction. In this example, you would aim to sell the contract higher than the initial price you paid. This action locks in your profit or limits your losses.

Costs and Trading Requirements

The margin on a trade tells you what percentage of the trade you’ll need to put down to enter the position. Brokers also require a maintenance margin if your trade goes into the negative. For example, if a trade has an initial requirement of $5,500 to enter a position and a maintenance margin of $5,000, it means that you’ll need to put down $5,500 to purchase the contract, and you’ll need to keep a balance of at least $5,000 in your account. Margin and leverage trading can turn small losses into large ones (and vice-versa), so it’s usually recommended that only experienced investors use it. 

Risks of Futures Trading

While futures trading doesn’t require you to deposit the entire value of a contract down to profit from price movements, these instruments are often highly leveraged. This can make them especially risky for beginners — consider the following risks before entering the market. 

• Risks associated with leverage: Thanks to margin trading, a small price movement in the underlying asset a futures contract is tied to can result in substantial gains or losses. You could experience significant financial risk if the market moves against your position.
• Margin calls: Besides the often-high cost of leverage, your broker will require you to maintain a minimum maintenance balance. Margin calls may require you to make additional deposits in the event of losses, which can further jeopardize your position. 
• Liquidity risk: Some futures contracts may have lower trading volumes, which can lead to wider bid-ask spreads and increased slippage. This can make it challenging to enter or exit positions at desired prices, especially in illiquid markets.

Generally, it’s a good idea to gain some experience stock trading or watching the market before attempting to trade futures contracts. 

Futures, Explained 

Now that you understand what futures trading is, trying your hand and entering the market can be tempting. However, it’s important to remember that futures contracts are complicated instruments that can result in sudden losses if you don’t know what you’re doing. We recommend using a stock or options paper trading account to get a handle on common brokerage tools or implements before subjecting yourself to the inherent risks of futures trading.