Futures Contract

A futures contract is a standardized derivative agreement obligating the buyer to purchase and the seller to deliver a specified quantity of an underlying asset (stock index, commodity, currency, interest-rate instrument) at a predetermined price on a specified future date. Unlike options, futures carry symmetric obligations for both parties. Futures are mark-to-market daily, meaning gains and losses are settled every trading day, and both parties post margin to guarantee performance.

Futures vs. forward-contract

Futures and forwards are cousins but differ critically:

• Futures: Standardized, traded on exchanges, daily mark-to-market, margin required, liquid.
• Forwards: Custom, bilateral over-the-counter, settled at maturity, no daily margin calls, illiquid.

A forward-contract on crude oil is a private deal between two parties. A crude oil futures contract is standardized (quantity, grade, delivery location, expiration) and traded on the CME.

Leverage and margin

A futures contract with a notional value of $100,000 might require only $5,000 initial margin. This 20:1 leverage amplifies gains and losses. A 1% move in the underlying translates to a 20% gain or loss on margin.

Traders must maintain maintenance-margin (typically 70–80% of initial margin). If losses drop the account below maintenance, a margin call forces the trader to deposit more funds or close the position.

Daily settlement: mark-to-market

At the end of each trading day, all futures contracts are revalued at the settlement price. Gains are credited; losses are debited directly to the trader’s account. This daily finality reduces counterparty risk compared to forwards (where losses accrue and are settled at maturity).

Types of underlyings

Stock index futures: E-mini S&P 500, NASDAQ-100, etc. Widely used for hedging portfolios and index trading.

Commodity futures: Oil, gold, wheat, natural gas. Essential for producers and consumers to hedge prices.

Currency futures: EUR/USD, GBP/USD. Used by importers, exporters, and currency traders.

Interest-rate futures: Treasury bond futures, Eurodollar futures. Used by banks, pension funds, and fixed-income traders.

Contango and backwardation

Futures prices typically differ from spot prices due to cost-of-carry. In contango, farther-dated contracts are more expensive (storage costs push prices up). In backwardation, farther-dated contracts are cheaper (convenience yield or supply shortage).

These relationships affect hedging strategies and create arbitrage opportunities.

Settlement and delivery

Cash settlement: Stock index and many interest-rate futures settle in cash. The contract is worth the difference between the final settlement price and your entry price.

Physical delivery: Commodity and currency futures often settle by physical delivery. The short side must deliver the actual commodity; the long side receives it.

See also