Futures Contracts

The Nature and Purpose of Futures Markets

Futures contracts represent legally binding agreements to buy or sell a specified asset at a predetermined price on a set future date. Unlike options, which grant rights without obligations, futures commit both parties: the buyer (long position) must purchase and the seller (short position) must deliver, or more commonly, both parties close out their positions before expiration through offsetting trades. This bilateral obligation creates symmetric exposure where gains to one party exactly equal losses to the other, making futures a zero-sum game before accounting for transaction costs.

The historical origins of futures markets lie in agricultural commodities, where farmers and grain merchants faced substantial price risk from planting to harvest. A wheat farmer planting in spring doesn't know what price will prevail at fall harvest—abundant global supplies could crash prices, while drought might send them soaring. Futures contracts allowed farmers to lock in prices months in advance, transferring price risk to speculators willing to bear it in exchange for potential profit. The Chicago Board of Trade, established in 1848, standardized these contracts and created a centralized marketplace that improved price transparency and liquidity.

Modern futures markets extend far beyond agricultural commodities to encompass crude oil, natural gas, metals, currencies, interest rates, stock indices, and even volatility itself. This breadth reflects futures' versatility for managing virtually any price risk and their efficiency as vehicles for speculation. The standardization of contract specifications—quality grades, delivery locations, contract sizes—eliminates the negotiation required for customized forward contracts while enabling liquid secondary markets where positions can be easily entered and exited.

Contract Mechanics and Settlement

Each futures contract specifies with precision the asset to be delivered, the quantity, the delivery location, the quality standards, and the expiration date. Crude oil futures on NYMEX, for instance, call for delivery of 1,000 barrels of West Texas Intermediate grade crude to Cushing, Oklahoma. S&P 500 futures specify cash settlement based on the index value times a multiplier rather than requiring delivery of all 500 stocks. Treasury bond futures deliver actual government bonds meeting specific criteria regarding maturity and coupon.

The standardization creates fungibility: all June 2025 crude oil futures are identical and interchangeable, allowing traders to offset positions easily. If you buy a contract in January and sell an identical contract in March, your position nets to zero and you've exited without needing to take delivery. In practice, over 95% of futures contracts close before expiration through offsetting trades, with actual physical delivery relatively rare except in commodities where end users genuinely need the product.

Daily settlement through marking to market distinguishes futures from forward contracts. Each day, exchanges calculate the profit or loss on all positions based on that day's settlement price and transfer funds between accounts accordingly. If you hold a long crude oil futures position and oil falls $2 per barrel, you owe $2,000 per contract (1,000 barrels × $2), which the exchange debits from your account and credits to short position holders. This daily cash flow eliminates the credit risk that builds up in forward contracts where gains and losses accrue unsettled until maturity.

Margin requirements create leverage that amplifies both gains and losses. Initial margin, the deposit required to open a position, typically represents only 5-15% of contract value—for a $100,000 crude oil contract, initial margin might be $7,000. This allows controlling $100,000 of exposure with just $7,000 capital, creating roughly 14:1 leverage. Maintenance margin, set slightly below initial margin, represents the minimum account balance required to keep positions open. If daily marking to market reduces your account below maintenance margin, you receive a margin call demanding additional funds or face forced liquidation.

Basis, Contango, and Backwardation

The relationship between futures prices and spot prices (current market prices for immediate delivery) reveals crucial information about supply-demand dynamics and carrying costs. The basis—defined as spot price minus futures price—can be positive or negative and typically varies with time to expiration.

Contango describes the common situation where futures prices exceed spot prices, with more distant contracts trading at progressively higher levels. This normal market structure reflects carrying costs: storing commodities requires warehouses, insurance, and financing, expenses that get priced into futures. For financial futures like stock indices, contango reflects the interest rate cost of buying now versus later, offset by dividends received from holding stocks.

The annualized cost of carry can be expressed as:

$$F = S \times e^{(r-d)T}$$

where $F$ is the futures price, $S$ is the spot price, $r$ is the risk-free rate, $d$ is the dividend yield, and $T$ is time to expiration in years. For commodities, the formula includes storage costs and convenience yield (the benefit of physically holding the commodity).

Backwardation occurs when futures trade below spot, typically signaling either strong immediate demand relative to expected future supply or high convenience yield from holding the physical commodity. During shortages, the premium for immediate delivery can drive spot prices well above futures. The 2008 crude oil spike saw severe backwardation as refiners desperately sought immediate supply, with the spot-futures spread reaching unprecedented levels.

Roll yield—the gain or loss from rolling expiring futures into new contracts—depends on market structure. In contango, rolling from an expiring contract into a higher-priced later contract imposes negative roll yield, dragging on returns. Commodity ETFs that hold futures suffer this decay during prolonged contango periods, causing them to underperform spot price movements substantially. In backwardation, positive roll yield enhances returns as positions roll from higher-priced near contracts into cheaper deferred contracts.

Hedging Applications

Producers and consumers exposed to commodity price risk use futures for hedging far more than speculation. An airline burning millions of gallons of jet fuel annually faces crushing losses if crude oil spikes, threatening bankruptcy regardless of operational efficiency. By purchasing crude oil futures, the airline locks in fuel costs months in advance, converting uncertain variable expenses into known fixed costs that allow reliable budgeting and pricing.

The hedge doesn't require holding futures to delivery—the airline isn't equipped to accept tankers of crude at Cushing. Instead, it closes the futures positions as it purchases actual fuel in spot markets. If crude rises, gains on the long futures positions offset higher fuel costs. If crude falls, losses on futures are offset by cheaper fuel purchases. The net effect stabilizes costs near the level prevailing when hedges were placed, sacrificing the chance to benefit from favorable price movements in exchange for protection against adverse ones.

Farmers employ similar hedging but from the short side, selling futures contracts at planting time to lock in prices for fall harvest. This protects against price collapses but means foregoing windfalls if prices surge. The decision of how much to hedge involves balancing risk reduction against opportunity cost, with most agricultural businesses hedging some baseline production while leaving some exposure to profit from favorable market moves.

Financial futures enable portfolio hedging across equity and interest rate risk. A pension fund holding $100 million in S&P 500 stocks can sell S&P futures to create synthetic cash exposure, protecting against market declines while retaining the underlying stock portfolio. This proves more efficient than selling stocks and buying them back, avoiding transaction costs, tax consequences, and tracking error. Bond portfolio managers similarly use Treasury futures to adjust duration exposure rapidly without trading the underlying bonds.

Speculation and Price Discovery

While hedgers transfer risk, speculators willingly accept it in pursuit of profit, providing the liquidity that makes hedging possible. Without speculators taking the opposite side, hedgers would struggle to find counterparties willing to absorb their risk at reasonable prices.

The speculation serves important economic functions beyond enabling hedging. Speculators' attempts to forecast future prices and profit from superior information or analysis contribute to price discovery—the process by which markets aggregate dispersed information into a single price signal. When droughts threaten wheat harvests, traders buying wheat futures drive up prices, signaling scarcity and encouraging conservation and additional planting. When inventories build and demand weakens, short selling pushes prices down, signaling abundance and discouraging overproduction.

The leverage available in futures markets attracts speculation that might not occur in spot markets. With 10:1 or higher leverage, a 10% price move generates 100% return on margin—or complete loss. This leverage cuts both ways, rewarding correct forecasts spectacularly while punishing errors with equal force. Most individual speculators in futures markets lose money, with academic studies suggesting 70-90% of retail futures traders experience net losses. The survivors tend to be either exceptionally skilled, extremely disciplined about risk management, or simply lucky—distinguishing between these proves difficult ex-ante.

Key Takeaway

Futures contracts serve essential economic functions by enabling price risk transfer, facilitating hedging of commodity exposures, and contributing to price discovery in major markets. The standardization, daily settlement, and margin requirements that characterize futures create both efficiency and leverage, making these instruments powerful tools for risk management while also enabling speculation that can generate outsized gains or losses. Understanding the mechanics of marking to market, the economics of basis and roll yield, and the appropriate applications for hedging versus speculation proves essential for anyone considering futures trading. For most investors, futures remain specialized instruments best left to professionals or avoided entirely in favor of less leveraged alternatives, though their existence benefits the broader economy by enabling hedging and revealing market expectations embedded in prices.

Further Reading

• CME Group: Introduction to Futures
• Hull: Options, Futures, and Other Derivatives (Textbook)
• Commodity Futures Trading Commission: Education Center