Futures contracts are financial agreements to buy or sell an asset at a before time determined price on a specified future date.

These standard contracts are traded on organized exchanges and are very good for global financial markets, used for hedging, speculation, and managing risk.

Definition

A futures contract obligates the buyer to purchase and the seller to deliver an underlying asset at a fixed price and date. The underlying asset can be:

• Commodities: Oil, gold, wheat, etc.
• Financial instruments: Currencies, stock indices, bonds.

Futures are not like spot markets where transactions occur immediately, but it set terms for a later date, enabling participants to plan for future market conditions.

Features of Futures Contracts

1. Standardization

Futures contracts have standardized terms, including:

• Contract size: Quantity of the underlying asset.
• Expiration date: When the contract settles.
• Tick size: Minimum price movement.

2. Leverage

Futures allow traders to control large positions with a fraction of the total value, known as margin.

3. Mark-to-Market

Profits and losses are calculated daily and adjusted in participants’ accounts based on the contract’s current value.

4. Exchange-Traded

Unlike over-the-counter (OTC) derivatives, futures are traded on regulated exchanges like the CME Group or Euronext, ensuring transparency and reducing counterparty risk.

How Futures Work

Example: A Commodity Futures Contract

A coffee distributor wants to lock in a stable price for coffee beans.

They enter a futures contract to buy 10,000 pounds of coffee at $1.50 per pound, with delivery in three months.

If the market price of coffee rises to $1.80 per pound, the distributor benefits from the locked-in price of $1.50, saving $0.30 per pound.

Settlement

• Physical Settlement: The actual asset is delivered at expiration.
• Cash Settlement: Only the price difference is exchanged, common for financial futures.

Uses

1. Hedging

• Producers and Consumers: Protect against price fluctuations in raw materials or goods.
• Currency Traders: Hedge against foreign exchange risk.

2. Speculation

Traders seek profits by predicting price movements without intending to take possession of the underlying asset.

3. Arbitrage

Exploiting price differences between futures and spot markets to earn risk-free profits.

Futures vs. Forward Contracts

Advantages 

1. Leverage
Increases gains (and losses) with minimal upfront capital.

2. Liquidity
High trading volume in futures markets ensures ease of entry and exit.

3. Hedging Efficiency
Protects against adverse price movements for producers, consumers, and investors.

4. Price Discovery
Futures markets play a vital role in determining the fair market value of assets.

Risks of Futures

1. Leverage Risk
While leverage magnifies profits, it also amplifies losses, potentially exceeding the initial investment.

2. Volatility
Rapid price movements can result in significant losses for unprepared traders.

3. Margin Calls
If the market moves against a trader’s position, they may be required to deposit additional funds to maintain their position.

4. Expiration Risk
Traders must manage positions carefully as expiration dates approach, especially for physical delivery contracts.

Types of Futures Contracts

1. Commodity Futures

Crude oil, gold, agricultural products.

Used by producers and consumers to hedge against price fluctuations.

2. Currency Futures

EUR/USD, GBP/JPY.

Helps multinational companies and investors manage foreign exchange risk.

3. Index Futures

Based on stock market indices like the S&P 500 or NASDAQ.

Allows investors to speculate on or hedge market movements.

4. Interest Rate Futures

U.S. Treasury bonds, Eurodollar.

Used to hedge against interest rate fluctuations.

Strategies in Futures Trading

1. Long Futures
Buy futures contracts to profit from rising prices.

2. Short Futures
Sell futures contracts to profit from falling prices.

3. Spread Trading
Trade the price difference between two related futures contracts.

4. Hedging Strategies
Offset potential losses in the spot market with futures positions.