Futures Contract Everything You Need to Know About Futures Trading

Core Description

• Futures contracts are standardized agreements traded on regulated exchanges, obligating both buyer and seller to transact a specific asset at a set price on a future date.
• They serve key roles in price discovery, risk management (hedging), and provide liquidity for a wide range of assets, from commodities to financial indices.
• The daily mark-to-market process and central clearing mechanisms offer transparency, mitigate counterparty risk, and enforce margin discipline.

Definition and Background

Futures contracts are legally binding agreements to buy or sell a specific asset—such as commodities, currencies, equity indices, or interest rates—at a predetermined price on a specified future date. Unlike spot transactions where immediate delivery and payment occur, a futures contract schedules settlement for a future date, with all terms standardized by the exchange where the contract is traded. This standardization includes contract size, asset quality, tick size (minimum price fluctuation), permitted settlement months, and delivery procedures.

Historical Evolution

Futures contracts have origins in ancient Mesopotamia, where forward-style agreements were used to stabilize agricultural prices. Organized futures trading began in the 18th century in Japan with rice exchanges, and became systematized in the United States during the 19th century, notably at the Chicago Board of Trade. These early developments addressed price volatility, disputes about quality, and counterparty risk.

From the late 20th century, futures trading expanded beyond agriculture. Important milestones included the introduction of currency and financial futures, the advancement of electronic trading platforms, and increasing regulatory oversight. Today, futures contracts are integral to global financial markets, supporting effective hedging, disciplined speculation, and arbitrage activities.

Standardization and Central Clearing

A distinctive feature of futures is their standardization. Exchanges establish precise contract terms, consolidating liquidity and enabling anonymous, transparent trading. Central counterparty (CCP) clearinghouses ensure settlement by standing between buy and sell orders, which significantly reduces default risk.

Asset Classes

Futures contracts cover a diverse range of assets, including:

• Commodities: crude oil, natural gas, gold, copper, wheat, corn, soybeans
• Financial: stock indices (such as S&P 500), government bonds, interest rates, sovereign currencies

This range enables market participants to hedge risks or speculate across global markets.

Calculation Methods and Applications

Pricing Futures Contracts

The theoretical value of a futures contract is derived from the "cost of carry" model, which reflects the relationship between the spot price and the futures price over time.

Cost of Carry Formula

Standard continuous form:

• F₀ = S₀·e^(r + u − y) T
  • F₀: Futures price today
  • S₀: Spot price today
  • r: Risk-free interest rate
  • u: Storage and financing costs
  • y: Income or convenience yield
  • T: Time to contract expiry

For example, crude oil futures often trade above spot (contango) when storage and financing costs are high; in situations of scarcity or a high convenience yield, futures might trade below spot (backwardation).

Equity Index Futures

Equity futures incorporate expected dividends:

• F₀ = S₀·e^(r − q) T
  • q: Continuous dividend yield

Daily Mark-to-Market and Margin

Futures positions are valued daily. Profits and losses are settled to traders' accounts in real time (variation margin):

• Profit/Loss = (F_closing − F_entry) × Contract size
  • For instance, if the E-mini S&P 500 future moves from 4,000 to 4,010 and each tick is worth $50, a long position would be credited $500 per contract, and a short debited the same amount.

Margin and Leverage

• Initial Margin: The deposit required to open a position.
• Maintenance Margin: The minimum balance required to maintain a position.
• Leverage: Leverage ≈ Notional Value / Margin Posted.

Example: A position with a notional value of $200,000 and a required margin of $10,000 implies 20x leverage; a 1% change in the underlying asset translates to a 20% move in margin.

Basis and Convergence

• Basis = Spot Price − Futures Price.
• The basis converges toward zero as expiry approaches, in the absence of market frictions. If convergence does not occur, arbitrageurs may engage in cash-and-carry strategies.

Contract Count for Hedging

• Hedge Ratio (h) = ρ(σ_S/σ_F)*
  • ρ: Correlation coefficient between spot and futures price changes
  • σ_S: Volatility of spot price
  • σ_F: Volatility of futures price
• Number of Contracts = (h × Exposure) / (Futures Price × Contract Size)*

Comparison, Advantages, and Common Misconceptions

Comparison to Other Instruments

Futures vs. Forwards

• Futures are standardized and exchange-traded, with daily settlement and central clearing.
• Forwards are customizable, over-the-counter (OTC) agreements that typically settle only at expiry, with greater counterparty risk.

Futures vs. Options

• Futures obligate both parties; profits and losses are not capped or limited.
• Options give the buyer the right, not the obligation, to buy or sell; buyers' losses are limited to the upfront premium.

Futures vs. Swaps

• Swaps generally involve the exchange of cash flows over time and are OTC; futures are single, tradable contracts with daily mark-to-market and margining.

Futures vs. ETFs/CFDs/Warrants/Stocks

• ETFs/CFDs may track futures returns but differ in transparency, margining, fees, and counterparty risk.
• Stocks convey company ownership, with associated voting rights and dividends, in contrast to the leveraged index exposure provided by futures.

Advantages

• Standardization results in deep liquidity, narrow spreads, and efficient pricing.
• Leverage provides considerable market exposure with relatively little capital.
• Transparency and regulation support market integrity.
• Risk transfer and hedging assist participants in managing or offsetting various risks.

Common Misconceptions

• Futures are not risk-free: Leverage amplifies both gains and losses, and margin calls can prompt rapid liquidation.
• Not all contracts result in physical delivery: Most positions are closed or rolled over before expiry.
• Futures are not the same as options: Options grant rights with defined downside, while futures confer direct obligations on both parties.

Practical Guide

Setting Objectives

Before trading or hedging with futures contracts, clearly define whether your intent is to hedge specific risks or to adopt a speculative position. Establish time horizons, risk parameters, capital allocation, and desired objectives.

Understanding Contract Specifications

Carefully examine the underlying asset, contract size, tick value, trading hours, settlement method (physical or cash), last trading and notice dates, and exchange-specific details. For example, a CME WTI crude oil futures contract represents 1,000 barrels per contract, with physical delivery to designated U.S. locations.

Managing Margin and Leverage

• Initial Margin: Understand how it is determined based on volatility and market risks.
• Maintenance Margin: Monitor balances closely; a drop below the required level triggers a margin call.
• Liquidity Assessment: Select contracts with adequate trading volume to minimize slippage and execution risk.

Position Sizing and Risk Control

• Volatility-based Sizing: Scale position sizes so that a typical adverse price move will not breach margin or exceed portfolio risk limits.
• Set Stops: Establish predetermined stop-loss and profit-taking levels, particularly during volatile conditions.

Hedging with Futures (Case Study)

Case: Airline Fuel Hedging (Fictitious Example, Not Investment Advice)

Suppose an airline in the United States wishes to hedge against rising jet fuel costs over the next six months.

1. Risk Assessment: The CFO assesses an exposure of 10,000,000 gallons of fuel.
2. Hedge Instrument: Direct jet fuel futures may be illiquid; the airline opts for NYMEX heating oil futures, due to their historical correlation with jet fuel.
3. Hedge Ratio: The optimal contract quantity is calculated using historical correlation and volatility data.
4. Execution: Trades are spread across multiple maturities to reduce concentration risk.
5. Monitoring: As market conditions evolve (e.g., oil prices, refining spreads), hedge positions are adjusted accordingly, with regular review of basis risk and ongoing fuel requirements.

Rolling and Expiry

• Most traders roll positions into future contracts before expiry to avoid physical delivery obligations.
• Remain aware of roll yield, especially in contango or backwardation markets, as it can affect overall returns.

Compliance and Tax Implications

• Familiarize yourself with position limits, reporting requirements, and local tax laws; for example, U.S. Section 1256 grants blended capital gains tax treatment for certain futures.
• Maintain thorough records for compliance, audit, and performance evaluation.

Resources for Learning and Improvement

• Textbooks:

  • "Options, Futures, and Other Derivatives" by John C. Hull
  • "Futures, Options, and Swaps" by Robert Kolb & James Overdahl
  • "Financial Risk Management" by Steve L. Allen

• Academic Journals:

  • Journal of Futures Markets
  • Journal of Finance
  • Review of Financial Studies

• Exchange Resources:

  • CME Group: contract specifications, margin calculators, educational materials
  • ICE and Eurex: tutorials, settlement calendars, white papers

• Regulatory Sources:

  • U.S. Commodity Futures Trading Commission (CFTC) Rulebook
  • European Securities and Markets Authority (ESMA) guidelines

• Online Courses and Certifications:

  • University-based MOOCs on derivatives and risk
  • FRM, PRM, and CFA programs for professional development

• Trading Platforms for Simulation:

  • Demo accounts from regulated brokers for simulation under real-market conditions

• Industry Case Studies:

  • Amaranth Advisors’ experience (energy futures, 2006)
  • Metallgesellschaft AG’s hedging strategies (oil, 1993)

FAQs

What is a futures contract?

A futures contract is a standardized exchange-traded agreement to buy or sell a specific asset at a set price on a future date, with both parties obligated to settle.

How do futures differ from options?

Futures obligate both buyer and seller to transact at expiration; options provide the right, not obligation, to buy or sell, with buyers’ risk limited to the premium paid.

What are initial margin, maintenance margin, and leverage?

Initial margin is the deposit required to enter a position. Maintenance margin is the minimum account balance permitted before a margin call. Leverage measures how much notional value is controlled per unit of posted margin.

Do all futures contracts settle with physical delivery?

No. Many contracts, such as equity index and certain commodities, settle in cash based on the difference between entry and final settlement prices. Most market participants close or roll their positions prior to delivery.

What is contango and backwardation?

Contango describes a scenario where futures trade above the spot price due to carrying costs, while backwardation occurs when futures are below the spot price, typically reflecting near-term scarcity or high convenience yield.

Are futures suitable for all investors?

Given their leverage and mark-to-market risk, futures suit investors who understand contract mechanism, risk management, and margin requirements.

How are profits and losses calculated in futures trading?

Profits and losses are recognized daily via marking to market, computed as the change in futures price multiplied by contract size.

What factors contribute to basis risk?

Basis risk resembles imperfect correlation between futures and the underlying exposure, affected by variations in contract terms, asset specifications, or local market dynamics.

Conclusion

Futures contracts are versatile financial instruments that facilitate risk transfer, hedging, and regulated exposure across a range of assets. Their standardized features, daily settlement process, and central clearing support market transparency and liquidity. However, leverage, volatility, and operational complexities call for disciplined risk management and thorough understanding.

Whether you are managing revenues, equitizing a portfolio, or seeking specific market exposures, understanding futures mechanics and prudent application is essential. Ongoing learning, vigilant monitoring, and sound trading practices are key to effective engagement with futures contracts, supporting informed and balanced investment decisions.