Futures Contract

Key takeaways
* A futures contract is a standardized agreement to buy or sell a specified quantity and quality of an asset at a predetermined price on a future date, traded on regulated exchanges.
* Main uses: hedging (locking in prices) and speculation (betting on price moves); arbitrageurs also trade futures to exploit pricing inefficiencies.
* Futures differ from forwards by being exchange-traded, standardized, and subject to daily settlement and margining.
* Contracts can settle in cash or by physical delivery; most traders close positions before expiration to avoid delivery.
* Trading involves leverage via margin accounts, which increases both potential gains and risks.

What is a futures contract?
A futures contract obligates a buyer to purchase—and a seller to deliver—a specified asset at a specified future date and price. Contracts are standardized for quantity, quality, and delivery terms so they can be traded on futures exchanges. Underlying assets include commodities (oil, grain, metals), currencies, interest-rate instruments, and equity indexes.

How futures work (mechanics and pricing)
* Standardization: Each contract specifies size (e.g., one crude oil contract on some exchanges = 1,000 barrels), delivery months, and quality standards.
* Pricing: Futures prices are tied to the spot price plus or minus factors such as the risk-free rate, time to maturity, storage costs, dividends (for financial underlyings), and convenience yield.
* Daily settlement (mark-to-market): Gains and losses are posted to traders’ accounts daily. Brokers require an initial margin to open a position and maintenance margin to keep it; shortfalls trigger margin calls.
* Settlement: At expiration a contract is either cash-settled or physically delivered, depending on contract terms. Most speculative traders close positions before expiration to avoid delivery obligations.

Uses of futures
* Hedging: Producers, consumers, and financial managers lock in prices to protect against adverse price movements (e.g., a farmer selling grain futures to guarantee a price at harvest).
* Speculation: Traders take directional positions to profit from anticipated price moves without intending to take delivery.
* Arbitrage: Traders exploit temporary price differences between related markets (e.g., futures vs. spot or across expiry months).

Common types of futures
* Agricultural: grains, cotton, coffee, livestock
* Energy: crude oil, natural gas, refined products
* Metals: gold, silver, copper
* Currencies: major and emerging-market FX futures
* Financial: equity-index futures (S&P 500, Nasdaq), interest-rate and government bond futures

Futures vs. forwards
* Futures: exchange-traded, standardized, subject to daily margining, regulated, and generally more liquid.
* Forwards: over-the-counter (OTC), customizable between counterparties, subject to counterparty credit risk, and not marked to market daily.

Example (simplified)
An oil producer expects to deliver one million barrels in one year. If one-year futures trade at $78/barrel, the producer can sell enough futures to lock in $78 million revenue regardless of the spot price at delivery. Each contract covers a fixed amount (e.g., 1,000 barrels), so the producer would use 1,000 contracts to hedge one million barrels.

Trading futures: practical considerations
* Access: Trading requires brokerage approval and a margin account. Major venues include CME Group, ICE, and CBOE.
* Leverage: Only a fraction of contract value is deposited as margin, amplifying returns and losses.
* Liquidity and contract specs: Check contract size, tick value, trading hours, and expiration dates. Many contracts expire on standardized days but specifications vary.
* Costs: Commissions, exchange fees, financing (implicit in pricing), and potential costs of physical delivery and storage if positions are held to expiration.
* Risk management: Use position sizing, stop-losses, and monitor margin requirements; be prepared for margin calls in volatile markets.

Risks
* Leverage risk: Small price moves can produce large gains or losses.
* Margin calls and forced liquidation risk.
* Basis risk: The futures price may not move perfectly in line with the underlying spot price.
* Counterparty and operational risk (lower on exchanges but still present via brokers).
* Delivery and storage costs if a contract results in physical delivery.

Who uses futures?
* Hedgers: producers, consumers, manufacturers, and institutional investors aiming to manage price risk.
* Speculators: traders and funds seeking profit from price moves.
* Arbitrageurs: market makers and traders taking advantage of mispricings.

Bottom line
Futures contracts are essential tools for managing price risk and expressing market views in a wide range of asset classes. Their standardized nature, exchange oversight, and daily settlement make them accessible and liquid, but leverage and margining introduce significant risk that requires disciplined risk management and an understanding of contract mechanics.