A futures contract is essentially a promise to buy or sell an asset in the future, and traders can buy and sell these promises. The futures contract defines the price these assets will trade for and the time at which the trade will take place.
Here's how futures contracts work and how they compare to similar securities.
Definition and Example of a Futures Contract
A futures contract is an agreement to either buy or sell an asset on a publicly traded exchange. The contract specifies when the seller will deliver the asset and what the price will be. The underlying asset of a futures contract is commonly either a commodity, stock, bond, or currency. Since futures contracts correspond with an underlying asset, they are an example of derivatives.
- Alternate name: Futures
Most futures contracts allow for a cash settlement instead of the physical delivery of the asset.
Futures contracts give businesses some level of certainty about what the price of an asset will be in the future, which allows for better planning. For example, a farmer planting wheat can have an idea of how much the crop will sell for when it's time to harvest. Investors and speculators, meanwhile, benefit from futures contracts, because they profit from anticipated price changes in these assets.
How Does a Futures Contract Work?
Future contracts are traded on a public exchange, such as the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), and the New York Mercantile Exchange (NYMEX), which are all owned by the CME Group.
The Commodities Futures Trading Commission (CFTC) regulates these futures exchanges.
The role of the futures exchange is similar to the role of a stock exchange. Just like with stock trading, exchanges provide a safe and efficient place to trade futures. The contracts go through the exchange's clearinghouse. Technically, the clearinghouse buys and sells all contracts.
A single futures contract must be very specific. It must be for the same exact asset, quantity, and quality. It must also be for the same delivery month and location.
How Futures Contracts Affect the Economy
Futures help companies lock in prices, thus benefitting both the buyers and sellers. A transportation company, for example, can use futures to lock in a guaranteed price for gasoline. This allows the transportation company to budget further out into the future more accurately than it would have been able to if it were dependent on market prices for gas.
Similarly, farmers use futures to lock in a sales price for their livestock or crops. They can also plan for how (and where) they will transfer possession of the goods under a contract. Just like the transportation company buying gas futures, farmers selling commodity futures can more accurately plan future revenues and costs without worrying about changing consumer demand and other variables.
Commodities futures allow economists to conduct price assessments and price forecasts for raw materials. These values are in part determined by the traders who trade futures and also by the analysts who monitor these markets.
Hedge funds use futures contracts to gain more leverage in the commodities market. They have no intention of actually buying, selling, or physically interacting with any commodity. Instead, they plan to buy an offsetting contract at a price that will make them money. In a way, they are betting on what the future price of that commodity will be.
Types of Futures Contracts
Futures contracts are written for commodities, stocks, bonds, or currencies.
Commodities are hard assets like wheat, gold, or oil. Of these, the most important may be oil futures, because they determine oil prices. Oil prices, in turn, are the major determinant in the price you pay at the gas pump. A rise in oil prices will raise the pump price as well.
Commodity prices are volatile, and commodity futures trading is a risky venture for traders.
Stocks and Bonds
Traders can trade financial instrument futures when they sense a shift in the economic trend. If they think rates will drop, for instance, then they may buy a futures contract for bonds (because bond prices rise when interest rates fall). If the trader thinks that stocks will rise, they may buy futures corresponding to the S&P 500.
Futures contracts for currencies are written in pairs. It's a promise to exchange a certain amount of one currency for an amount of another currency. For instance, if a trader believes that the value of the U.S. dollar will rise in comparison to the value of the Euro, then they'll buy a USD/EUR future that matches their sentiment.
Traders can also trade options on futures. Just like with stock options, futures options give the purchaser the right (the "option") to buy or sell a futures contract by a certain day. Futures options cost less than purchasing an actual futures contract. They can reduce risk (if used wisely), and they also allow more traders to achieve greater diversification.
Futures Contract vs. Forward Contract
|Futures Contracts||Forward Contracts|
|Traded on an exchange||Traded over-the-counter (OTC)|
|Standardized||Private and customizable|
|Relatively more safe than forwards||Relatively more risky than futures|
Futures contracts are similar to forward contracts, but there are some key differences that are important to understand. The simplest way to think of the differences is that the forward contract is a more personalized form of a futures contract. The delivery time and purchase price for a forward contract are customized to address the particular needs of the buyer and seller.
That level of customization comes with some drawbacks. Exchanges only allow for the trading of standardized contracts. Since forwards are customized, they are traded outside of standardized exchanges, or "over-the-counter" (OTC). Since they aren't traded on an exchange, there's less accountability with forwards, and they carry a higher risk of default.
- A futures contract is an agreement to trade an asset at a certain price on a certain day in the future.
- Futures contracts allow companies to offset the risk and better plan for upcoming quarters.
- Futures contracts can be written for commodities like oil or financial instruments like stocks, bonds, and currencies.