How Do Futures Contracts Work?

Futures contracts are agreements to buy or sell a specific underlying asset, such as a commodity or a stock, at a predetermined future price and date. Investors use futures contracts – futures for short – as a risk hedging tool, and speculators hope to leverage them to profit from the underlying asset's price fluctuations.

At expiration, under the contract terms, a futures contract buyer must purchase the underlying asset at the agreed-upon price while the seller is obligated to sell it. 

With over $29 billion futures contracts traded globally in 2021, futures make up a significant portion of the financial market, which makes it imperative that you understand how this unique financial tool works.

How Do Futures Contracts Work?

A futures contract is an agreement between two parties, a buyer and a seller, to exchange a specified asset at a fixed price at a future date. When a futures contract ends, the buyer must buy the asset, and the seller must sell it to the buyer.

Here are the mechanics of a typical futures contract:

1. The buyer and seller agree on the type and quantity of the underlying asset and the delivery date and price.
2. The buyer and seller deposit an initial margin deposit to open positions, which serves as collateral for future price movements.
3. The asset price fluctuates based on market conditions, and the value of the futures contract also changes accordingly.
4. The buyer or seller can close out their position at any time by taking an offsetting trade or by taking delivery of the underlying asset.
5. The contract expires, and the buyer or seller must either take delivery of the underlying asset or offset the position by entering into an equal and opposite contract.

Futures contracts are standardized, meaning the contract terms are the same for all buyers and sellers. Futures are settled daily, and the traders must pay or receive the difference between the closing price and the settled price.

In the U.S., the Commodity Futures Trading Commission (CFTC) regulates futures trading, and you can trade them on organized exchanges such as the Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE) and the European Energy Exchange (EEX).

Types of Futures Contracts

The world of futures trading is diverse and offers various financial and commodity-based contracts. A futures contract exists for you if you're interested in indices, currencies, debt, energies, metals or agriculture products. 

Here are common types of futures contracts available: 

Commodity futures: These are agreements to buy or sell a physical commodity at a fixed price and date in the future. Farmers, producers and investors employ these contracts to manage price risks.

Commodities include oil, metals, natural gas, livestock and grains. Investors can sell futures contracts for these commodities to sell them at a future date at a set price. This way, farmers and producers can plan and know how much they will be paid for their products, regardless of the market price at the delivery time.

Currency futures: Currency futures contracts allow traders to buy or sell a specific currency at a fixed price and date in the future, providing exposure to the currency's exchange rate. The value of the contract fluctuates based on market conditions, resulting in a profit or loss depending on the price movement of the currency.

Interest rate futures: Interest rate futures are agreements to buy or sell government bonds at a fixed price and date in the future. They allow investors to bet on interest rate movements and hedge against interest rate risk.

Stock futures: These futures are used to protect against the risk of a stock's price going down, to make a profit by guessing which way the stock's price will go or to trade. They can also be used as a gauge of how confident or worried investors are about the stock in general.

Single stock futures are agreements to buy or sell a specific stock at a future date, while stock market index futures track the movement of a group of stocks. Investors can use single stock futures to place spread trades or hedge against single stock price changes.

Benefits of Investing in Futures

While futures investing comes with its unique challenges, it also has benefits over other types of investment.

Hedging: Futures are powerful tools that can help you manage and hedge against different risks. Companies engaged in international trade use futures to protect themselves against currency fluctuations, interest rate changes and price volatility for commodities like oil, crops and metals. Using futures and derivatives, these companies can lock in prices and interest rates in advance, giving them greater control and predictability in their operations.

Diversification: Futures investing can expose you to a wide range of asset classes that may not be as easily accessible through traditional stock, bond and options markets. Adding futures to your investment portfolio allows you to tap into opportunities in different global markets, reducing the risk of your portfolio being overly exposed to one particular market.

High volatility: On average, futures prices tend to fluctuate more than stock or bond prices, providing traders with more opportunities to profit from short-term price movements. However, this increased volatility also means a greater risk level is involved in trading futures.

More transparent: Futures trading may be less susceptible to insider trading because the prices of futures contracts are typically based on factors such as weather or other economic indicators rather than on information that may be known only to a select group of people. 

Lower costs: Commissions on futures trades are generally lower than those associated with other types of investments.

High level of leverage: Most futures contracts allow traders to put up a small percentage of the total value of the underlying asset as a margin, typically between 10-15%. Traders can control a much larger position than they would be able to with other types of investments, such as stocks or bonds. That way, the investors' profit will multiply if the trade moves in their favor.

High liquidity: Commodity markets in which futures contracts are traded are highly liquid, meaning that transactions can be completed quickly and with minimal market impact. High liquidity can help traders minimize the chances of market movements between the time of decision and execution, which can be beneficial for those looking to trade with a high degree of precision.

Compare Futures Contract Brokers

Are you looking to trade futures contracts? Futures contracts are traded on various exchanges such as the CME, ICE and EEX through broker-dealers and online trading platforms. Check out Benzinga's deep insight and valuable reviews on some of the top online trading platforms and broker-dealers.

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