What Are Futures Contracts?
A futures contract is a legally binding agreement between two parties to buy or sell a specific asset at a predetermined price on a specified future date. Unlike options, which give the holder the right but not the obligation to transact, futures contracts carry a firm obligation for both the buyer and the seller. When you enter a futures contract, you are committing to fulfill the terms of that contract at expiration, either by taking or making delivery of the underlying asset, or by settling the difference in cash.
Futures contracts are standardized, meaning the exchange specifies the exact quantity, quality, delivery date, and delivery location for each contract. This standardization is what distinguishes futures from forward contracts, which are privately negotiated and customized between two parties. The standardization of futures allows them to be traded on regulated exchanges with transparent pricing, deep liquidity, and a centralized clearinghouse that guarantees contract performance.
Futures markets serve two primary economic functions. First, they provide a mechanism for price discovery, allowing the market to establish consensus prices for assets at future dates based on current supply and demand expectations. Second, they enable risk transfer, allowing producers, consumers, and investors to hedge against adverse price movements by locking in prices today for transactions that will occur in the future. A wheat farmer can sell futures contracts to lock in a price for next season's harvest, and an airline can buy crude oil futures to stabilize fuel costs.
How Futures Markets Work
Futures contracts are traded on organized exchanges that provide a regulated, transparent marketplace. The largest and most well-known futures exchange in the world is the CME Group, which includes the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX), and the Commodity Exchange (COMEX). Other major global futures exchanges include the Intercontinental Exchange (ICE), Eurex, and the London Metal Exchange (LME).
Every futures trade involves a buyer and a seller. The buyer agrees to purchase the underlying asset at the contract price on the delivery date, and the seller agrees to deliver it. However, the buyer and seller do not deal directly with each other. Instead, a clearinghouse stands between every trade, acting as the counterparty to both sides. The clearinghouse guarantees that both parties will fulfill their obligations, virtually eliminating counterparty risk. This is one of the key advantages of exchange-traded futures over privately negotiated forward contracts.
Futures contracts have standardized expiration dates, typically on specific months depending on the contract. As a contract approaches its expiration, traders who do not want to take or make physical delivery will close their positions by entering an offsetting trade. In practice, the vast majority of futures contracts are closed before expiration, and fewer than 3% result in actual physical delivery.
Prices in futures markets are determined by open auction or electronic matching systems where bids and offers are continuously matched. Futures prices are marked to market daily, meaning gains and losses are calculated and settled at the end of each trading day. If your position has lost value, the loss is deducted from your account. If it has gained value, the gain is credited. This daily settlement process is fundamental to how futures trading works and directly affects your margin requirements.
Futures vs Stocks vs Options
Understanding how futures differ from other financial instruments helps clarify both their potential uses and their unique risks. The following comparison highlights the key structural differences between futures, stocks, and options.
| Feature | Futures | Stocks | Options |
|---|---|---|---|
| Obligation | Both buyer and seller are obligated to fulfill the contract | No obligation beyond purchase price | Buyer has the right but not obligation; seller is obligated |
| Leverage | High leverage (control large positions with small margin deposit) | No inherent leverage (unless using margin account) | Moderate leverage through premium pricing |
| Expiration | Yes, contracts have specific expiration dates | No expiration (hold indefinitely) | Yes, options expire on specified dates |
| Settlement | Physical delivery or cash settlement at expiration | Ownership transfer at purchase | Exercise for shares (stock options) or cash settlement |
| Maximum Loss | Potentially unlimited for both buyer and seller | Limited to amount invested | Limited to premium paid (for buyers) |
| Daily Settlement | Yes, marked to market daily | No (unrealized gains/losses until sold) | No daily settlement requirement |
| Ownership | No ownership of underlying asset | Direct ownership of company shares | No ownership unless option is exercised |
Types of Futures Contracts
Futures contracts exist across a wide range of asset classes, each serving different hedging and speculative purposes. The major categories of futures contracts include the following.
Stock Index Futures
Stock index futures are contracts based on the value of a stock market index such as the S&P 500, Nasdaq-100, Dow Jones Industrial Average, or Russell 2000. These contracts allow traders to speculate on the direction of the broad stock market or to hedge an existing stock portfolio against market-wide declines. Index futures are always cash-settled because there is no physical asset to deliver. The E-mini S&P 500 futures contract is one of the most actively traded futures contracts in the world.
Commodity Futures
Commodity futures cover physical goods including energy products (crude oil, natural gas, gasoline), precious metals (gold, silver, platinum), industrial metals (copper, aluminum), and agricultural products (corn, wheat, soybeans, coffee, sugar, cotton). Commodity futures have the longest history of any futures market, dating back to the mid-19th century at the Chicago Board of Trade. These contracts can be settled by physical delivery of the commodity or by cash settlement, depending on the specific contract. For more on the underlying markets, see our guide to commodities investing basics.
Currency Futures
Currency futures allow traders to buy or sell a specific amount of one currency in exchange for another at a future date. Major currency futures contracts include the Euro (EUR/USD), Japanese Yen (JPY/USD), British Pound (GBP/USD), and Canadian Dollar (CAD/USD). Currency futures are used by multinational corporations to hedge foreign exchange risk and by speculators to profit from anticipated currency movements.
Interest Rate Futures
Interest rate futures are based on debt instruments such as U.S. Treasury bonds, Treasury notes, and Eurodollar deposits. These contracts allow traders to speculate on or hedge against changes in interest rates. Treasury bond futures are among the most liquid futures contracts and are closely watched as indicators of market expectations for monetary policy and economic conditions.
Cryptocurrency Futures
Cryptocurrency futures are a newer addition to regulated futures exchanges. The CME Group launched Bitcoin futures in December 2017 and Ethereum futures in February 2021. These contracts are cash-settled and provide a way to gain exposure to cryptocurrency price movements within a regulated exchange environment, without the need to hold the actual digital assets in a crypto wallet.
Popular Futures Contracts
The following table lists some of the most actively traded futures contracts, along with their key specifications. Understanding contract size and tick value is essential for calculating the dollar impact of price movements on your positions.
| Contract | Ticker | Exchange | Contract Size | Tick Value |
|---|---|---|---|---|
| E-mini S&P 500 | ES | CME | $50 x S&P 500 Index | $12.50 per 0.25 point |
| Micro E-mini S&P 500 | MES | CME | $5 x S&P 500 Index | $1.25 per 0.25 point |
| E-mini Nasdaq-100 | NQ | CME | $20 x Nasdaq-100 Index | $5.00 per 0.25 point |
| Crude Oil (WTI) | CL | NYMEX | 1,000 barrels | $10.00 per $0.01 |
| Gold | GC | COMEX | 100 troy ounces | $10.00 per $0.10 |
| Corn | ZC | CBOT | 5,000 bushels | $12.50 per 0.25 cent |
| 10-Year Treasury Note | ZN | CBOT | $100,000 face value | $15.625 per 1/64 point |
| Euro FX | 6E | CME | 125,000 euros | $12.50 per 0.0001 |
| Bitcoin | BTC | CME | 5 bitcoin | $25.00 per $5.00 |
Margin and Leverage in Futures
One of the defining characteristics of futures trading is the use of margin, which in futures markets works differently than margin in stock trading. When you trade futures, you do not pay the full value of the contract upfront. Instead, you deposit a fraction of the contract's total value, known as the initial margin, as a good-faith performance bond. This margin deposit typically ranges from 3% to 12% of the contract's total value, depending on the contract and market volatility.
For example, if the E-mini S&P 500 futures contract (ES) is trading at 5,000 points, the full contract value is $250,000 (5,000 x $50). However, the initial margin requirement might be approximately $12,000 to $15,000, meaning you control a $250,000 position with a deposit of roughly 5% of its value. This creates a leverage ratio of approximately 20:1, meaning every 1% move in the underlying index creates a roughly 20% gain or loss relative to your margin deposit.
The maintenance margin is the minimum amount of equity you must maintain in your account while the position is open. If your account equity falls below the maintenance margin level due to adverse price movements, your broker will issue a margin call, requiring you to deposit additional funds immediately to bring your account back to the initial margin level. If you fail to meet the margin call, the broker has the right to liquidate your positions without notice to limit further losses.
Going Long vs Going Short
Futures markets allow you to profit from both rising and falling prices, which is one of their key features. Unlike stocks, where short selling requires borrowing shares and paying interest, going short in futures is just as straightforward as going long.
Going Long (Buying Futures)
When you go long a futures contract, you agree to buy the underlying asset at the contract price on the expiration date. You go long when you believe the price of the underlying asset will rise. If the price increases above your entry price, you profit. If the price falls below your entry price, you lose money.
For example, suppose you buy one E-mini S&P 500 futures contract at 5,000. If the index rises to 5,050, your profit is 50 points x $50 per point = $2,500. If the index falls to 4,950, your loss is 50 points x $50 per point = $2,500. Because of leverage, this $2,500 gain or loss occurs on a margin deposit of roughly $13,000, representing a return of approximately 19% in either direction on what may have been only a 1% move in the index.
Going Short (Selling Futures)
When you go short a futures contract, you agree to sell the underlying asset at the contract price on the expiration date. You go short when you believe the price will fall. If the price drops below your entry price, you profit. If the price rises above your entry price, you lose money.
For example, if you sell one crude oil futures contract at $75 per barrel and the price drops to $72, your profit is $3 per barrel x 1,000 barrels = $3,000. If the price instead rises to $78, your loss is $3 per barrel x 1,000 barrels = $3,000. Short positions in futures carry the same risk profile as long positions: losses can be substantial and are amplified by leverage.
Futures Settlement Methods
When a futures contract reaches its expiration date, it must be settled. There are two methods of settlement, and the method used depends on the specific contract specifications.
Physical Delivery
Physical delivery means the seller delivers the actual underlying commodity or asset to the buyer at a designated delivery location, and the buyer pays the contract price. Physical delivery is common in commodity futures such as crude oil, gold, corn, and wheat. In practice, only a small percentage of futures contracts result in physical delivery because most traders close their positions before expiration by entering an offsetting trade.
Cash Settlement
Cash settlement means no physical asset changes hands. Instead, the difference between the contract price and the settlement price (the market price at expiration) is calculated, and the appropriate amount is credited to the winning party and debited from the losing party. Cash settlement is used for contracts where physical delivery would be impractical, such as stock index futures, interest rate futures, and cryptocurrency futures.
Futures Pricing: Spot Price and Cost of Carry
The price of a futures contract is closely related to, but not identical to, the current market price (or spot price) of the underlying asset. The difference between the futures price and the spot price is primarily explained by the cost of carry, which includes storage costs, insurance, financing costs (the opportunity cost of tying up capital), and any income generated by holding the underlying asset (such as dividends for stock indexes).
The theoretical futures price can be expressed as: Futures Price = Spot Price + Cost of Carry. In practice, supply and demand dynamics, market sentiment, and expectations about future events cause the actual futures price to deviate from this theoretical value.
Contango
Contango occurs when the futures price is higher than the current spot price. This is the normal condition for most commodity markets because it reflects the costs of storage, insurance, and financing required to hold the physical commodity until the delivery date. In contango, longer-dated futures contracts trade at progressively higher prices than nearer-dated contracts.
Backwardation
Backwardation occurs when the futures price is lower than the current spot price. This can happen when there is strong immediate demand for the physical commodity or when the market expects future supply to increase or demand to decrease. Backwardation is often seen during supply shortages or when current demand significantly outstrips available supply.
Hedging with Futures
Hedging is the original and most fundamental purpose of futures markets. Hedging involves taking a futures position that is opposite to your existing exposure in the physical or financial market, thereby reducing or eliminating the risk of adverse price movements. Hedgers are willing to give up some potential upside in exchange for protection against downside risk.
Consider a corn farmer who expects to harvest 50,000 bushels of corn in six months. The farmer is concerned that corn prices may fall before the harvest. To hedge this risk, the farmer sells 10 corn futures contracts (each representing 5,000 bushels) at the current futures price of $5.00 per bushel. If corn prices fall to $4.50 by harvest time, the farmer loses $0.50 per bushel on the physical corn sold at market price but gains $0.50 per bushel on the short futures position. The futures hedge effectively locks in the $5.00 price regardless of where the market moves.
Portfolio managers use stock index futures to hedge equity portfolios. If a fund manager holds a large stock portfolio and is concerned about a short-term market decline, they can sell S&P 500 futures contracts to offset potential losses. This allows them to maintain their stock positions and avoid the transaction costs and tax consequences of selling the underlying stocks while still protecting against downside risk.
Speculating with Futures
Speculation in futures markets involves taking directional bets on the future price of an asset without any underlying exposure to hedge. Speculators are attracted to futures because of the leverage, liquidity, and ability to profit from both rising and falling markets. They provide essential liquidity to futures markets, making it easier for hedgers to enter and exit positions.
However, speculating with futures is inherently risky. The leverage that makes futures attractive for speculation also magnifies losses. A speculator who is wrong about the direction of a market move can lose their entire margin deposit rapidly, and in extreme market conditions, may owe additional funds to their broker. Studies consistently show that the majority of individual retail speculators in futures markets lose money over time.
Speculative strategies in futures include directional trading (betting on the direction of a single market), spread trading (betting on the price difference between two related contracts, such as crude oil for different delivery months or the spread between gold and silver), and basis trading (betting on the difference between the spot price and the futures price). For a broader perspective on derivatives strategies, see our guide to options and derivatives basics.
Micro and Mini Futures
Traditional futures contracts represent large notional values that can be prohibitive for individual retail investors. To make futures more accessible, exchanges have introduced micro and mini versions of popular contracts with smaller contract sizes and correspondingly lower margin requirements.
E-mini contracts, introduced by the CME in 1997, are one-fifth the size of their full-size counterparts. The E-mini S&P 500 (ES), with a multiplier of $50 per point, quickly became the most actively traded equity index futures contract in the world. E-mini contracts exist for major stock indexes, currencies, and some commodities.
Micro E-mini contracts, launched in 2019, are one-tenth the size of E-mini contracts. The Micro E-mini S&P 500 (MES) has a multiplier of just $5 per point, making the initial margin requirement roughly $1,300 to $1,800 depending on market conditions. This makes it possible for retail traders to participate in futures markets with substantially less capital. Similarly, Micro Gold (MGC), Micro Crude Oil (MCL), and Micro Bitcoin (MBT) contracts allow smaller-scale participation in commodity and cryptocurrency futures.
Risks of Futures Trading
Futures trading carries several significant risks that every investor must understand before participating. These risks go beyond the normal price risk associated with investing in stocks or bonds.
Leverage risk is the most important risk in futures trading. Because you control a large contract value with a small margin deposit, even modest price movements can result in substantial percentage gains or losses relative to your margin. A 2% move in the underlying asset can translate to a 20% to 40% gain or loss on your margin deposit, depending on the leverage ratio. In extreme cases, losses can exceed your entire account balance.
Margin call risk occurs when adverse price movements reduce your account equity below the maintenance margin level. Margin calls require you to deposit additional funds immediately, often within one business day. If you cannot meet the margin call, your broker may liquidate some or all of your positions at whatever prices are available, potentially locking in large losses at the worst possible time.
Liquidity risk exists in less actively traded contracts or during periods of market stress. In illiquid markets, you may not be able to close your position at a favorable price, or the bid-ask spread may be wide enough to significantly affect your execution costs. Liquidity risk is particularly relevant for less popular contract months and niche commodity contracts.
Gap risk refers to the possibility that prices can move sharply between trading sessions. Futures markets have specific trading hours, and significant news events can cause prices to open substantially higher or lower than the previous close. A stop-loss order may not protect you from gap risk because the order may be filled at a price far from your intended stop level.
Expiration and rollover risk arises from the finite life of futures contracts. If you hold a contract as it approaches expiration, you must either close the position, roll it into a later-dated contract (which may trade at a different price due to contango or backwardation), or prepare for settlement. Mismanaging contract expiration can result in unexpected delivery obligations or forced liquidation at unfavorable prices.
