What Is a Futures Contract?
In finance, a futures contract (sometimes called futures) is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell is known as the forward price. The specified time in the future—when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.
More about Futures Contract
The contract's settlement occurs when it reaches its expiration date. At this point, whoever holds the futures is obligated to buy or sell the underlying asset for the agreed-upon price.
Although futures can be held until they expire, many speculators and traders prefer to buy and sell the contracts on the open market before their expiration. After taking a futures contract position, there are three main actions that futures traders can use for exiting their positions.
The first and most common one is offsetting, which refers to closing a position by creating another of equal value and size.
The second common alternative is known as rollover. Futures traders may decide to roll over (extend) their position before the contract is over.
To do so, they first offset their position and then open a new batch of futures contracts of the same size but with a different expiration date (further in the future).
The third option is to wait for the expiration date and contract settlement. At settlement, all parties involved are legally obligated to exchange their assets (or cash) according to their futures contract position.
While futures contracts are derivative, they differ from other familiar products such as options and forwards.
Options give a trader a choice to buy an asset at a specific time but do not require that they do so, while execution is a requirement in a futures contract.
Forward contracts are similar to futures contracts but are typically informal or private agreements between two parties rather than contracts traded through a formal exchange.
In addition, forward contracts tend to offer traders more flexibility when customizing terms, while futures contracts are standardized and more restrictive.
Several different types of assets can be traded using futures contracts, such as fiat currencies, stocks, indexes, government-issued debt instruments, and cryptocurrencies.
Oil, precious metals, agricultural goods, and other commodities are also traded through futures contracts.
Beyond the various underlying assets that futures can be based on, there are also two different ways to settle the contracts. In physical settlements, the underlying asset is physically delivered to the party who has agreed to buy it.
Cash settlements, by contrast, do not involve the direct transfer of the asset.
Like most trading instruments, futures traders often use technical analysis indicators and fundamental analysis to get further insights into the price action of futures contracts markets.
Trading Futures Contracts
Retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to acquire 1,000 barrels of oil, but they may be interested in capturing a profit on oil price moves.
Futures contracts can be traded purely for profit, as long as the trade is closed before expiration. Many futures contracts expire on the third Friday of the month, but warranties do vary, so check the contract specifications of any contracts before trading them.
For example, it is January, and April contracts are trading at $55. If a trader believes that oil price will rise before the contract expires in April, they could buy the warranty at $55. This gives them control of 1,000 barrels of oil. They are not required to pay $55,000 ($55 x 1,000 barrels) for this privilege, though. Instead, the broker only requires an initial margin payment, typically a few thousand dollars for each contract.
The profit or loss of the position fluctuates in the account as the price of the futures contract moves. If the loss gets too big, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin.
The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1,000). Alternatively, if the price drops to $50 and they close out the position, they lose $5,000.