What is a Futures Contract?
A Futures Contract is a financial derivative in which there is an obligation between counterparties to exchange an underlying asset at a pre-determined price on an agreed-upon expiry date.
How Does a Futures Contract Work?
Futures are a contractual agreement between two counterparties – the buyer and the seller – to exchange a particular asset at a predetermined price on a later date.
- Buyer: Obligated to purchase the underlying asset at the predetermined price and receive the asset once the futures contract has expired.
- Seller: Obligated to sell the underlying asset at the agreed-up price and to deliver the asset to the buyer per the schedule outlined in the contract.
Futures contracts offer buyers and sellers the ability to lock in purchase (or sale) prices of an asset for a specific date in the future, often to mitigate the risk of unfavorable price movements from the date of the agreement until the expiration date.
A futures contract will state terms such as the following:
- Quantity of Asset
- Purchase Price of Asset (or Sale Price from Seller’s Viewpoint)
- Date of Transaction (i.e. Payment and Delivery Timing)
- Quality Standards
- Logistics (e.g. Location, Method of Transport if Applicable)
Buyer vs. Seller: How to Profit from Futures?
As part of the futures contract, the buyer must purchase the underlying asset at the predetermined price, while the seller must follow through with the sale at the negotiated terms.
- Buyer: The buyer of the futures contract is said to be taking a “long” position, i.e. profits if the price of the underlying asset increases.
- Seller: The seller is said to be holding a “short” position, i.e. profits if the price of the underlying asset declines.
From the buyer’s perspective of a futures contract, the buyer profits if the underlying asset rises in value above the purchase price set by the contract.
On the other hand, if the underlying asset declines in value below the purchase price set by the contract, the seller profits.
Types of Underlying Assets in Future Contracts
A futures contract can be structured with a variety of underlying assets.
| Types |
Examples |
| Physical Commodities |
- Bushels of Corn
- Wheat
- Lumber
|
| Precious Metals |
|
| Natural Resources |
|
| Financial Instrument |
|
Historically, much of the futures trading volume was related to physical commodities, where the transaction was physically settled (i.e. delivered in person).
But nowadays, futures contracts are more frequently based on assets with no physical delivery necessary since they can be cash-settled, which appeals to a broader range of investors.
Futures for Hedging and Speculation Trading
Investors utilize futures primarily for purposes of either hedging or speculative trading.
- Hedging: If there is a specific asset that an investor intends to sell in a large quantity someday in the future, futures protect against downside risk (i.e. futures can help recoup losses if the asset were to decline substantially in value).
- Speculation: Certain traders make speculative bets surrounding asset price movements (i.e. rise or fall in price based on event catalysts) in the hopes of receiving high returns.
Futures are more often used for the former – hedging against price fluctuations in a certain asset – which helps not only investors manage risk, but also businesses (e.g. agriculture, farms).
Future Contracts vs Forward Contracts (“Forwards”)
Future and forward contracts are similar in that both are formal agreements between two parties to purchase or sell an underlying asset at a predetermined price by a specified date.
Both futures and forwards provide market participants with the option to hedge risk (i.e. offset potential losses).
But the distinction between futures and forwards lies in how futures trading is facilitated on exchanges and settled through a clearinghouse (and thus are more standardized with more centralized oversight).
- Since futures are traded on exchanges, the terms contained in these contracts are more standardized – plus, the changes in prices can be seen in real-time.
- The Commodities Futures Trading Commission (CFTC) monitors and regulates transactions.
- A clearinghouse is formed specifically to facilitate transactions involving derivatives and ensure deals are completed per the contract (and assumes a large portion of the risk on behalf of buyers and sellers).
By contrast, forward contracts are private agreements with the settlement date clearly stated in the agreement, i.e. a “self-regulated” contract either traded over-the-counter (OTC) or off-exchange.
In effect, forward contracts have more exposure to “counterparty risk,” which refers to the chance that one party might refuse to fulfill their side of the deal.
Futures vs. Options
Options provide the buyer with the choice to exercise their rights (or let them expire worthless), but futures are an obligation that both the buyer and seller must hold up their ends of the deal no matter what.
Unique to a futures contract, the transaction must be completed irrespective of changes in the underlying asset’s price.
