Futures contract

A futures contract is a special kind of agreement used in finance. It lets two people agree to buy or sell something, like a type of commodity or a financial instrument, at a price set today, but the actual exchange happens later in the future. This helps both sides plan ahead because they know exactly what the price will be, even though they don’t meet until later.

These contracts are traded in special places called futures exchanges, where buyers and sellers come together. The person who agrees to buy is called the long position holder, and the person who agrees to sell is the short position holder. To make sure both sides follow through, they often put some money aside with a trusted third party, called a margin.

Futures contracts started with things like crops and later included resources like oil. In 1972, financial futures began, and now we have contracts for things like currency, interest rates, and stock market indexes. These contracts help people manage risk and also let traders guess where prices will go, hoping to make a profit.

Origin

The Dōjima Rice Exchange in Osaka, started in 1697, is often called the first market for buying and selling promises to trade in the future. It helped samurai, who were paid in rice, change their rice into money after poor harvests.

Later, in 1864, the Chicago Board of Trade created the first standard contracts for future trading, called futures, based on grain. This led to many different types of futures contracts and exchanges around the world. By the 1930s, most futures trading was in wheat. In 1972, a new exchange was created for financial futures, starting with currency futures, then adding interest rate futures and stock market index futures in later years.

Risk mitigation

Futures contracts help people manage risk before a set date. Both sides put down some money, called a margin, to show they can keep their promise. This money changes daily based on the current price, so if one person loses, the other gains. This keeps things fair until the day they must exchange what was agreed upon. On that day, they use the current price, not the original one, because all changes have already been handled.

Margin

Main article: Margin (finance)

To keep trading safe, special rules are used on places where people trade things they will get or sell in the future. These rules help make sure that if one person can't pay, another person will still get what they need.

Sometimes, people who already own something or who have trades that balance each other out don't need to follow all these rules. There are different kinds of money that traders need to put down to show they can pay if things go wrong, like when they first start a trade or to keep their trades going each day. If the money they have gets too low, they might be asked to put in more right away.

Expiry and final settlement

Expiry, also called expiration in the U.S., is the specific day when a futures contract stops trading and reaches its final settlement price. For many types of contracts, like those for stock indexes and interest rates, this usually happens on the third Friday of certain months. At this time, the next contract becomes the main one for trading.

Final settlement is when the contract is completed. This can happen in two ways: either by physically delivering the actual item traded, like commodities, or by making a cash payment based on a reference rate or index value. Most contracts are settled in cash, especially for things like stock indexes that can't be physically delivered.

Pricing

When there is plenty of a product available or it can be easily made, the price of a futures contract is set using special math rules called arbitrage. This is common for things like stock indexes, bonds, and crops after they are harvested. But when a product isn’t available yet—like crops before harvest or certain money tools—the price is set by how much people want it versus how much is available in the future.

In simple cases where the product exists and can be stored, the future price is based on today’s price plus a small extra amount for risk and storage. This helps make sure everyone gets a fair deal. When the product isn’t available yet, the price depends on what people think it will be worth in the future, adjusted for today’s market conditions.

Futures contracts and exchanges

Futures contracts are agreements to buy or sell something in the future at a set price. These "somethings" can be many types of goods or values, like crops, money, or even interest rates. People have traded things like rice and silk for centuries, and today we trade many more items.

In the 1970s, special places called exchanges started trading these future agreements for money-related items. Now, there are many exchanges all over the world where people can trade futures contracts. Some well-known exchanges include the Chicago Mercantile Exchange, which trades many different types of futures, and others like the London International Financial Futures Exchange and the Tokyo Commodity Exchange.

Most futures contracts have special codes made of five letters or numbers. The first two letters show what is being traded, the next letter shows the month, and the last two numbers show the year. For example, on the Chicago Mercantile Exchange, January is written as "F," February as "G," and so on, up to December, which is "Z." So, CLX25 means it is a contract for crude oil (CL) to be traded in November (X) of the year 2025 (25).

Futures contracts users

Futures traders are usually in one of two groups: hedgers and speculators. Hedgers are people or businesses that use futures to protect themselves from price changes. For example, farmers might sell futures contracts for their crops to lock in a price and plan better.

Speculators, on the other hand, try to make money by guessing how prices will change. They don't usually plan to take or give the actual product, but instead they trade contracts to benefit from price movements. This can help move risk from those who need protection to those who are willing to take a chance.

Options on futures

Options are often traded on futures, and these are called "futures options". A put is the right to sell a futures contract, and a call is the right to buy one. Both have a set price called the strike price where the trade happens if the option is used.

Investors can choose to sell (write) options or buy them. Sellers take on more risk because they must fulfill the contract if the buyer uses their option. The price of an option depends on supply and demand and includes a premium paid to the seller for taking this risk.

Options on futures expire more often than the futures themselves, sometimes daily. Examples include options based on gold, stock indexes like the Nasdaq or S&P 500, or commodities like oil. Stock exchanges and their clearing houses offer information about these products.

Main article: Options Main articles: Put option, Call option

Futures contract regulations

In the United States, all futures transactions are watched over by the Commodity Futures Trading Commission (CFTC), a group that helps make sure rules are followed. If someone breaks these rules, the CFTC can give out fines or other punishments. Each trading place can also have its own rules and can add extra fines.

The CFTC shares reports every Friday about how many trades people have open. These reports are called the 'Commitments of Traders Report' and show different kinds of trading activities.

To work in this field, people usually need to pass a test called the National Commodity Futures Examination (Series 3). Some also choose to get special certificates to show they know more about these markets.

Definition of a futures contract

A futures contract is an agreement to buy or sell something in the future at a price set today. This agreement is made between two people who do not know each other yet. The item being traded is often something like grain, oil, or money.

The price for this contract is called the futures price. When someone agrees to a futures contract, they do not pay anything upfront. If the price of the item changes before the delivery date, the person holding the contract receives or pays the difference. At the agreed delivery time, the person pays the set price and gets the item. This price at delivery time should match the current market price of the item.

Futures versus forwards

A forward contract is similar to a futures contract because both agree to exchange goods at a set price on a future date. However, they differ in important ways.

Futures contracts are traded on exchanges and are standardized, meaning they all look the same. Forward contracts are private agreements between two parties and can be customized. Futures contracts require daily payments to protect against price changes, while forwards do not. This daily payment system in futures reduces the risk that one party might not fulfill the contract, as a clearing house guarantees the trade. Forwards, lacking this daily check, carry more risk that one party might not be able to deliver or pay on the final day.

Because of these differences, futures and forwards behave differently in trading and risk management.