Futures Contracts

A futures contract sets terms for a later transaction

A futures contract is a standardized agreement traded on an exchange to buy or sell a specified quantity and quality of an asset for delivery or settlement under terms tied to a future date. The contract defines size, delivery month, grade or instrument, delivery location when applicable, and last trading day. Buyers take a long position; sellers take a short position. The clearinghouse stands between market participants and manages performance obligations.

A futures contract is not a stock purchase made with a small deposit. The trader is responsible for the contract’s gains and losses and may be obligated to make or take delivery, or settle in cash, according to the contract. Many participants close or offset a position before delivery, but that is a trading decision, not a guarantee that every contract can be exited at a desired price.

Margin is a performance bond

Futures margin is collateral intended to support the trader’s ability to meet obligations. It is not a down payment that buys a partial ownership stake in the commodity or an upper limit on possible loss. The exchange or clearing organization sets requirements, and a futures commission merchant may require more. Initial margin is posted when opening a position; maintenance margin is the minimum balance that must be maintained under the applicable terms.

Futures positions are marked to market. Gains and losses are credited or debited as settlement prices change, typically each trading day. If the account falls below the maintenance level, the customer may need to deposit additional funds. The broker can liquidate positions under its agreement if funds are not provided. Because margin is only part of the contract’s notional exposure, a modest price change can be large relative to the cash initially posted.

Suppose one futures contract covers 1,000 units of a commodity and the futures price is $50 per unit. Notional exposure is $50,000. If initial margin is $5,000, that amount is collateral, not the full purchase price and not the maximum loss. A $2 per unit price move changes contract value by $2,000. For a long position, a rise creates a gain and a fall creates a loss; for a short position, the signs reverse.

Daily settlement can create cash needs before expiration

Assume a long position in a contract for 5,000 units. The settlement price falls by $0.20 per unit in one day. The account is debited $1,000 for that day’s loss, before fees. If it falls another $0.30 the next day, the additional debit is $1,500. The total two-day loss is $2,500, even though the trader has not bought or sold the underlying asset in a cash market.

If the account began with $3,000 of initial margin and the maintenance level is $2,000, the $1,000 daily debit would reduce it to $2,000. Another adverse move could trigger a margin call. The broker’s specific rules and deadlines matter; a trader cannot assume they will have until expiration to fund a loss. Market gaps can produce losses that exceed the available account balance.

Margin rules and requirements change with market conditions and contract terms. Do not rely on a remembered percentage. Check current exchange and broker requirements for the specific contract, and consider the possibility that requirements rise during volatility. A trader may need to post additional collateral even when the long-term economic position remains unchanged.

Hedgers and speculators use the same contract differently

A producer may sell futures to reduce uncertainty about a future selling price. A consumer may buy futures to reduce uncertainty about a future purchase cost. A speculator may take a long or short position to profit from a price change without owning or needing the physical commodity. Both hedging and speculation use the same market, but the risk being managed or assumed differs.

Suppose a farmer expects to harvest 20,000 bushels and is concerned that market prices may fall before sale. If a futures contract covers 5,000 bushels, selling four contracts creates a short futures position matched in quantity to the expected crop. If futures prices fall by $0.50 per bushel, the futures gain is about $10,000. If the local cash price also falls by $0.50, the lower crop-sale revenue is partly offset. The hedge reduces some exposure, subject to basis and quantity differences.

The farmer could lose on the futures position if prices rise, while receiving more for the crop in the cash market. A hedge trades some upside for reduced price uncertainty. The farmer must still consider whether the futures contract’s grade, delivery location, month, and quantity match the actual crop sale. If the farmer cannot deliver at the contract location or grade, they may need to offset the position before delivery.

Delivery and offsetting are distinct outcomes

Some futures contracts are physically delivered, while others settle in cash. For a physically delivered contract, the agreement specifies the asset, grade, delivery location, and procedures. A trader who does not want to make or take delivery typically offsets the position before the relevant deadline by entering an opposite position in the same contract month. The two positions can offset economically, subject to price and transaction details.

Do not confuse a futures position with an intention to exchange the commodity immediately. A buyer can close a long contract by selling the same contract month; a seller can close a short by buying it back. If the position remains open into the delivery process, the trader may face operational and financial obligations. Investors should know the last trading day, first notice day where applicable, and broker cutoff, because they can precede the final calendar date shown on a platform.

Cash settlement uses a defined reference or index to calculate the final amount rather than transferring the physical asset. The final settlement method can still produce large losses or gains. The contract specification controls. A trader should understand settlement before opening the position, not after the market approaches expiration.

Basis risk and contract mismatch

A futures hedge rarely eliminates every price risk because the cash asset and futures contract may not move in perfect lockstep. Basis is commonly the difference between local cash price and futures price. Basis can change because of transportation, storage, local supply, quality, timing, or market conditions. If the cash price falls less than futures, the short futures gain may exceed the local revenue decline; if it falls more, the hedge may be incomplete.

A company expecting to buy heating fuel might use a related futures contract, but the fuel grade or delivery location may differ from its actual purchase. If the correlation weakens, the hedge may not offset the business exposure as expected. A hedge can also be imperfect in quantity: contracts come in fixed sizes, while a company’s future need may be uncertain. The trader may choose to hedge only a portion to avoid being overhedged.

Risk controls for futures positions

Before trading, calculate notional exposure, the dollar effect of a price move, initial and maintenance margin, and the cash available for variation margin. Identify whether the contract is physically delivered or cash settled, and note the last trading and delivery dates. Set a position size that can withstand adverse daily settlement rather than relying only on the initial margin deposit.

A futures position can provide useful price-risk management, but it can also magnify losses and require cash at short notice. Contract standardization supports exchange trading and clearing; it does not remove basis risk, liquidity risk, or the possibility of a rapid loss. The clearest analysis states the underlying exposure, the contract’s unit and month, the direction of the position, and how a specified price change affects the account.

A futures hedge in cash-flow terms

Suppose a bakery expects to buy 10,000 bushels of wheat in three months. It buys two futures contracts, each for 5,000 bushels, at $6 per bushel. If futures later rise to $6.50, the long futures position has an unrealized gain of $5,000 before fees and settlement differences. If the bakery’s local cash price rises from $6.10 to $6.55, the physical purchase costs $4,500 more than it would have at the original price, so the futures gain offsets much of the higher cost. The remaining difference reflects basis movement and imperfect timing.

If futures fall to $5.50 instead, the position loses $5,000 through daily settlement, while the bakery may buy wheat for less. The hedge is doing its job of reducing uncertainty, but the cash margin calls can arrive before the bakery purchases the wheat. If the business lacks liquidity, it may be forced to close the hedge and lose the intended protection. The analyst should evaluate both economic offset and short-term funding capacity.

A producer may use the opposite position. A farmer expecting to sell 10,000 bushels could sell two futures contracts. A price decline then produces a short futures gain while the crop’s sale revenue falls; a price rise produces a futures loss while the crop earns more. The hedge can stabilize expected revenue without ensuring a particular final price, because local basis, production quantity, quality, and timing can differ.

Contract specifications determine the calculation

If a contract is quoted in index points, identify the dollar multiplier before computing profit and loss. A one-point change in a contract with a $50 multiplier changes its value by $50 per contract; a five-point change changes it by $250. For a commodity contract, multiply the price change by the contract quantity. A trader holding three contracts experiences three times the per-contract change, before commissions and other adjustments.

The contract month matters because prices can differ across delivery dates. A hedger who closes one month and opens a later month has rolled the position and may realize a spread gain or loss between the contracts. The exposure continues, but the old contract is replaced by a new one with its own price and margin requirement. Roll cost can affect the hedge result even if the underlying spot price does not change.

A long futures position is exposed to price declines and a short position is exposed to price increases, but neither description alone captures the full risk. Delivery requirements, daily settlement, margin policy, contract liquidity, and basis all affect the realized result. For an exam question, convert the price move into dollars using the contract size and number of contracts, then determine which direction benefits the long or short. Keep the performance bond separate from the contract’s total exposure.

For a cash-settled equity index contract with a $100 multiplier, a settlement change from 4,000 to 4,010 points changes contract value by $1,000. A long position gains that amount and a short loses it, before fees. If the contract is physically delivered, the investor must instead understand the deliverable and procedures. Contract multipliers and settlement methods differ, so calculate only after reading the specification.

The contract’s last trading day can differ from its delivery date. Check both, along with the broker’s cutoff for customers who must close a position before delivery begins.