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Futures

A clear, simple guide to futures contracts: what they are, how they work, why people use them, key risks, and a practical example. For traders, hedgers, and students.

What is a futures contract?

A futures contract is an agreement to buy or sell an asset at a set price on a future date. The asset can be a physical good like oil or wheat, or a financial item like a stock index or a currency. The contract standardizes how much of the asset is traded, when it expires, and where it is settled.

Futures make it possible to lock in a price now for delivery later. That simple idea changes how businesses and traders manage risk and make bets on price moves.

How futures work

  • Two parties agree to the contract on an exchange.
  • The contract specifies the asset, quantity, price, and expiration month.
  • Instead of delivering the asset right away, both parties post margin, a kind of security deposit.
  • Each day the exchange adjusts account balances for gains and losses. This is called marking to market.
  • Before expiration, traders can close their position by entering the opposite trade. Some contracts are settled in cash. Others may require physical delivery.

Key pieces:

  • Contract size: how many units per contract, for example 5,000 bushels of corn.
  • Tick size and tick value: smallest price move and its dollar value.
  • Expiration: the month when the contract ends.
  • Margin: initial deposit and maintenance level.

Long vs short

  • Long position: you agree to buy in the future. You profit if the price rises.
  • Short position: you agree to sell in the future. You profit if the price falls.

If the market moves against you, you may need to add money to your account to meet margin calls.

Why people use futures

  1. Hedging. Businesses use futures to reduce price risk. A farmer can lock in a price for next season's crop. An airline can lock a price for jet fuel.
  2. Speculation. Traders take positions to profit from price moves. Futures let them use leverage and control a large amount of an asset with a smaller cash outlay.
  3. Arbitrage. Traders exploit price differences across markets to lock in risk-free profits.
  4. Price discovery. Futures markets show what buyers and sellers expect prices to be in the future.

Example

A crude oil futures contract has a size of 1,000 barrels. Suppose the current futures price is $70 per barrel.

  • Buying one contract controls 1,000 barrels at $70. The notional value is $70,000.
  • If the price rises to $72, your contract gains $2,000. If it falls to $68, you lose $2,000.

You do not need $70,000 to trade. You post margin, for example $5,000. That is where leverage comes from. Small price moves can create big gains or losses relative to the margin.

Marking to market and margin calls

Every trading day the exchange recalculates gains and losses. If your margin falls below a required level, you get a margin call. You must deposit cash to restore the margin. If you cannot, the broker may close your position.

This daily settlement reduces credit risk but increases the need to manage cash.

Settlement: cash vs physical

  • Cash settlement: you receive or pay the difference in cash when the contract expires.
  • Physical delivery: the actual commodity or asset must be delivered according to contract rules. Most traders avoid delivery by closing positions before expiry.

Common risks

  • Leverage risk. You can lose more than your initial margin.
  • Market risk. Prices can move fast and gap past limit orders.
  • Liquidity risk. Some contracts may be hard to exit at a fair price.
  • Basis risk. The futures price may not track the exact cash market you care about.
  • Expiration risk. Near expiry, prices can move oddly as traders roll positions into later months.

Where futures trade and who clears them

Futures trade on exchanges like CME Group, Intercontinental Exchange, and Eurex. A clearinghouse sits between buyers and sellers and guarantees trades. That reduces counterparty risk. Brokers connect traders to the exchange and handle margin.

Quick glossary

  • Contract month: the month the contract expires.
  • Tick: smallest allowed price change.
  • Notional value: price times contract size.
  • Initial margin: deposit to open a position.
  • Maintenance margin: minimum account balance to keep a position.

Final notes

Futures are a simple concept with powerful effects. They let people lock a price now for later. That ability helps businesses manage costs and lets traders take leveraged positions. The same power that helps can cause large losses when markets move against you. If you trade futures, learn margin rules, know how to close positions before delivery, and start small.

If you want, I can add a simple worksheet to calculate profits and margins for specific contracts like S&P 500 futures or crude oil.

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