Futures Contract

What Is a Futures Contract?

A futures contract is an agreement between two parties to buy or sell a particular asset at a predetermined price on a specified date in the future. The asset can be a physical commodity such as crude oil, wheat or gold, or a financial instrument such as a stock index or a government bond. Each contract specifies the quantity, quality and delivery terms of the underlying asset, which is what makes it "standardized."

Futures are traded on organized exchanges, which act as intermediaries and guarantee that both sides will honor the agreement. To manage that risk, the exchange's clearinghouse requires each trader to post a margin deposit, a fraction of the contract's total value, and adjusts account balances daily through a process called mark-to-market.

How Futures Work

The buyer of a futures contract is said to hold a long position and agrees to take delivery of the asset. The seller holds a short position and agrees to make delivery. Most traders never actually exchange the underlying goods. Instead, they close their positions before expiration by taking an offsetting trade, locking in a profit or loss based on how the price moved.

Because prices change every day, gains and losses are credited or debited to each account daily. If the market moves against a position, the trader may receive a margin call requiring additional funds.

Why It Matters to Investors

Futures are widely used for two main purposes. Producers and consumers, such as farmers or airlines, use them for hedging to reduce exposure to price swings. Speculators use them to take a view on price direction, often with significant leverage, since a small margin deposit controls a much larger position.

That leverage cuts both ways. Losses can exceed the initial margin, and the risk is generally higher than with owning shares outright. Futures also differ from options, because the holder of a futures contract is obligated to complete the trade rather than merely having the right to do so. Understanding contract expiration dates and the difference between spot price and futures price is important before trading these instruments.