What Are Futures?
A futures contract allows its parties to buy or sell a specific underlying asset at a set future date. The underlying asset can be a commodity, a security, or some other financial instrument.
These agreements are best entered after you’ve learned some basics, and should not be invested in on a whim. Start by doing your homework and learning the basics.
KEY TAKEAWAYS
Futures are a kind of derivative, an agreement whose returns depend on the value of an underlying asset.
A futures contract commits the buyer to buy or a seller to sell an underlying asset at a preset price and date.
Investors use futures to speculate on or hedge against changing prices for a security, commodity, or financial instrument.
Forward contracts
Forward Contracts are agreements between two parties, while futures are standardized contracts sold on an exchange.
You can trade futures in commodities, currencies, interest rate changes, livestock, oil and gas, securities, and much more. The most traded futures are for equities.
For many investors, futures contracts, with their different terms and trading strategies, can be daunting. But the learning curve hasn’t stopped increasing numbers of investors from entering futures markets in recent years. According to the Futures Industry Association, futures trading worldwide more than doubled from 12.1 billion contracts in 2013 to 29.2 billion in 2023.
They are not new, though, and futures have long been used as insurance for farmers and traders against devastating changes in nature and the market.
For millennia, forward contracts have been employed to lock in future prices for financial stability no matter what happened to the harvest that year.
But many have also used them to speculate and profit from changing prices in the market. For example, the ancient Roman orator Cicero left evidence that the Romans used forward contracts, in a letter criticizing traders who raced to get ahead of spreading knowledge of a major grain shipment arriving to profit by locking others into higher prices with them.
While much has changed as forwards have become standardized as futures contracts and exchanges offer ever-more-sophisticated products, the basics remain the same. Below, we guide you through the kinds of futures, who trades them, and why, all while showing that you don’t need to get on horseback to beat news of a grain-filled ship arriving to gain from these investments.
Futures Basics
Futures commit you to buying or selling an underlying asset at a specific price on a preset date. We use “underlying asset” in the vaguest sense since investors trade futures for virtually all commodities, financial securities, and more. You can buy or sell futures related to weather events like temperature, rainfall, hurricanes, and even snow (useful for firms relying on it for tourists); shipping futures for freight rates and such; electricity and network telecommunication bandwidth; and real estate for volatility in property prices.
While the U.S. Commodity Futures Trading Commission (CFTC) has banned futures trading in American elections, the University of Iowa’s Henry B. Tippie College of Business for decades has been running (for research purposes) an online futures market where contract payoffs are based on real-world events such as political elections, companies’ earnings per share, and stock price returns.
In 2022, the Chicago Mercantile Exchange began offering event-based futures where you essentially bet yes or no for questions on the value of indexes, currencies, commodities, and so on, with terms ending daily. In 2024, the exchange added quarterly and yearly expirations.
But let’s not get ahead of ourselves. First, we’ll set out some essential distinctions for forward and futures contracts before turning to who uses them and the kinds of underlying assets most often at play.
Forward Contracts
A forward contract is the oldest type of these agreements, predating the trading in futures that formalized “to arrive” contracts in the latter half of the 19th century.
A forward is an agreement between two parties to transact in the future, with one party taking the long position and the second taking the short position; they are also called the long and short forwards.
The long forward must buy an asset from the short forward at a future time. What’s being bought in the future is called the “underlying asset.” As we’ve seen, this can be many things, but grains and other farm products were the assets when the Chicago Board of Trade opened in 1848.
Today, forwards are traded over the counter and customized for the parties involved. Despite variations, forwards include the following:
Contract price
This is the agreed-upon “forward price” that the underlying asset will be bought or sold for in the future. It’s determined when the contract is entered into.
Counterparties: The parties involved in the contract: a buyer (long position) and a seller (short position)
delivery date: This is the date when the underlying asset will be exchanged.
Underlying asset: The commodity, financial instrument, or other asset bought or sold
Quantity of the asset: The contract specifies the exact amount of the underlying asset to be delivered or received.
Settlement method: Forwards are settled by physically delivering the underlying asset or through cash.
Terms and conditions: Any extra terms about the execution of the contract, including how defaults are handled, the rights of the parties, and any conditions that, once met, mean the forward can be modified or voided
Forward Contract Example
Let’s flesh this out with an example. Suppose a couple owns a farm and expects to harvest 5,000 bushels of wheat in six months. They’re worried about what a fall in the price of wheat would mean for covering their bills while getting ready for the next season. .
Meanwhile, a local organic cereal producer needs a consistent supply of wheat but is concerned that prices might go up, which would raise production costs. So, the farmers and the cereal company sign a forward contract that would include the following:
Underlying asset: 5,000 bushels of wheat
Contract price: $5 per bushel. This price is agreed upon when the contract is signed.
Quantity: 5,000 bushels
Delivery date: Six months after the contract’s signing date
Settlement method: Physical delivery of the wheat to the cereal producer
Parties: The wheat farmer (seller) and the cereal manufacturer (buyer)
Under these terms, the farmers have to deliver 5,000 bushels of wheat to the cereal manufacturer in six months, and the cereal producer must pay the farmer $5 per bushel when that’s done, no matter what happens to the price of wheat in the meantime. If the price goes up to $7 a bushel, the farmers get less than they would have otherwise, but the cereal producer makes out. Alternatively, if the price goes down to $3 a bushel, the farmers still keep the stable income they need, and the cereal manufacturer is out more money than otherwise, but in the meantime, neither party had to stress over volatility in the wheat market.
Futures contracts take this concept, standardize its elements, and make it tradable on exchanges.
Futures Contracts
A futures contract is like a forward, but it’s done through an organized exchange, committing traders to buy or sell an underlying asset at a preset price on a future date. Like forwards, some contracts require physical delivery. But others are settled in cash, the amount of which is the difference between the agreed-upon price and the market price when the future date arrives.
Futures are traded through open outcry in trading pits in an auction or through electronic screen-based systems with centralized exchanges like the Chicago Mercantile Exchange. There are also cryptocurrency exchanges like Binance that trade futures, including those with and without an expiration date.
The role of the futures exchange is not to buy or sell the contracts but to enable trades, ensure that they are legally conducted, check that they follow the exchange’s rules, and publish the trading prices. This last element is crucial for price discovery, helping other buyers and sellers find a mutually agreeable price based on supply and demand.
Since a futures contract is an obligation in the future, a trader can sell contracts without buying contracts first. Traders who sell more contracts than they buy have a short futures position, while traders who buy more contracts than they sell have a long futures position.
Futures Contract Example
Let’s make this concept concrete with an example. Suppose an airline wants to hedge against the risk of rising fuel prices. To manage this risk, it enters into a futures contract to buy crude oil at a predetermined price. At the same time, an oil company is trying to lock in a price for its oil in case prices fall. These transactions take place on a regulated exchange, ensuring standardized terms and avoiding the need for the parties to know each other directly.
Under these futures contracts, the airline agrees to buy, and the oil producer agrees to sell 1,000 barrels of crude oil for $60 per barrel on a certain date. Here’s what the details might look like:
Contract months:
Crude oil futures are available for several months ahead, providing flexibility for hedging strategies. The airline might choose a contract with a delivery month that aligns with its predicted fuel needs, such as “CLZ24” for December 2024 delivery.
Contract size: The standard contract size for crude oil futures is 1,000 barrels. This standardization makes it easy to calculate the contract’s total value, which, at a trading price of $60 per barrel, would be $60,000.
Deliverable grade: This notes the quality and grade of the product that can be delivered under the contract. For crude oil futures, this includes details like how heavy the oil is and its sulfur content.
Exchange: The contract is traded on a regulated exchange like the New York Mercantile Exchange, where many contracts for crude oil are sold.
Last trading day: The final day on which trading can occur for the contract is usually a few business days before the delivery month begins. For crude oil futures, this might be the last trading day in the month preceding the contract month, ensuring all obligations are settled before delivery.
Price quoted in: Prices for crude oil futures are quoted per barrel.
Settlement type: Futures contracts can be settled through physical delivery of the underlying asset or cash settlement. For crude oil futures like “CLZ24,” physical delivery is more standard, though many participants close their positions before the delivery date to avoid actual delivery.
Tick size: The contract specifies the minimum tick size, which could be $0.01 per barrel for crude oil, translating to a $10 change in the contract’s total value for each tick movement.
Ticker: The specific contract for crude oil can be identified by a ticker symbol such as “CL” for crude oil, followed by a suffix for the delivery month and year—for example, “CLZ24” for a contract expiring in December 2024.
With forwards, there’s a risk that the other party won’t fulfill the contract. This is mitigated for futures by the exchange clearinghouse, which guarantees the contract. While each side is taking a risk that the price they pay now is close to the actual price at the settlement month, each party insures against the risk of a wide swing against them in oil prices.
Who Uses Futures?
Measured by volume, most futures are traded by commercial or institutional entities. Of these, most are hedgers looking to cut their risk of financial losses, as in our examples thus far. Buying futures for these traders is a form of insurance. Meanwhile, speculators trade futures contracts only to profit from price fluctuations. They don’t want the underlying assets but buy or sell futures based on their predictions about future prices.
Futures traders include arbitrageurs and spread traders, investors who use price discrepancies between different markets or related instruments to profit. They are a kind of speculator, buying and selling futures or other financial instruments to profit from cross-market price differences. They use sophisticated software to search markets for price discrepancies and execute trades quickly before they disappear.
Hedgers
Hedgers use futures contracts to mitigate the risk of price changes going too low when the time comes for them to sell an asset or increasing too much if they have to buy it later in the spot market. These traders include producers, consumers, or investors with exposure to the underlying asset who employ futures contracts to lock in prices, effectively insuring against price volatility.