What Futures Are

Why this matters

The options in the first module gave one side a right and the other an obligation. Futures are plainer and harsher: both sides are obliged. They're the contracts in which grain, oil, metals, and much else are priced for future delivery. Few individual investors need to trade them. Some hold them indirectly, since many commodity funds track futures and not the commodity itself.¹ This lesson explains what the contract is. The next covers the margin system that makes futures dangerous in inexperienced hands.

A promise about a price

The Commodity Futures Trading Commission, the US regulator, starts its explanation with a wheat farmer. A farmer who plants a crop runs the risk of losing money if the price of wheat falls before the harvest is sold. Selling wheat futures fixes the price in advance. On the other side, a miller who'll need wheat can fix what they'll pay. Futures markets let producers and consumers of commodities hedge in this way, and the certainty helps both run their businesses.²

A commodity futures contract is a legally binding agreement to buy or sell a particular commodity at a future date for a fixed price and quantity.¹ The buyer, who is said to be long, has agreed to buy. The seller, who is short, has agreed to sell. Neither has a choice about it later, and neither pays the other anything at the start.

What the exchange fixes

Futures typically trade on organized exchanges that set standardized terms for the contracts. The exchange fixes the amount of the commodity, the delivery months, the last trading day, the delivery locations, and the acceptable qualities or grades.² The only thing left for buyers and sellers to settle is the price.

Standardization is the point. It makes it possible for large numbers of people to trade the same instrument, which makes the market liquid.² The cost is fit: a farmer's wheat may not be exactly the contract's grade or in the contract's place, a gap that Hedging with Derivatives returns to.

What a contract is worth

Contract value = Price × Contract size

At $6.00 a bushel, one 5,000-bushel wheat contract covers $30,000 of wheat. Because the size is fixed, every change in the price means a fixed change in dollars: one cent a bushel is $50 a contract.

Price when the position is closed	Change per bushel	Buyer's result	Seller's result
$5.00	−$1.00	−$5,000	+$5,000
$5.70	−$0.30	−$1,500	+$1,500
$6.00	$0.00	$0	$0
$6.30	+$0.30	+$1,500	−$1,500
$7.00	+$1.00	+$5,000	−$5,000

The result is a straight line in both directions. The buyer gains a dollar for every dollar the seller loses, and neither side's loss is limited by a premium.

Compare that with an option. A call buyer's loss stops at the premium and the gain doesn't. A futures buyer has the whole move, up and down, as if they owned the wheat. The seller has the mirror image, including a loss with no upper limit if the price keeps rising.

The clearing house

A promise to trade months from now is only as good as the person who made it. Futures solve that with a clearing house, which acts as the buyer to all sellers and the seller to all buyers. When a contract is bought or sold, it's technically bought from or sold to the clearing house, and not the party on the other side of the trade.²

Two things follow. Nobody has to assess the stranger they traded with, because their contract is with the clearing house. And a position can be cancelled. Since each contract is with the same party, someone who has bought a contract and then sells an identical one has offset the position, and the contract is extinguished.² The clearing house protects itself by requiring margin from everyone and settling gains and losses every day, which is the subject of Margin and Leverage in Futures.

Almost nobody takes delivery

A futures contract is a promise to deliver, and most are never delivered. By volume, most futures contracts are liquidated by offsetting.² The CFTC's farmer shows why. The contract's delivery point may be hundreds of miles from the farm, so delivering on it would mean paying to ship the wheat there. The farmer instead buys back the contracts before the delivery date and sells the actual wheat locally.²

If so few contracts are delivered, why have delivery at all? Because the possibility keeps the futures price honest. The purpose of the delivery provision is to ensure that the futures price and the cash market price converge.² If futures were far above the price of real wheat as delivery approached, someone would buy wheat, sell futures, and deliver. If they were far below, buyers would take delivery. So the two are pulled together at the end.

The practical lesson for anyone holding a contract is the reverse of the one for options. An option left alone expires. A futures contract left alone turns into an obligation to deliver or receive the real thing. FINRA's example is accepting delivery of 40,000 pounds of cattle.¹ Traders who aren't in the business close or roll their positions before that point.

Who's in the market

Commodity futures are most often traded by commercial enterprises that depend on commodities for their business: a cereal company buying wheat futures to secure prices, an airline buying energy futures.¹ These are hedgers. They have a risk already and use futures to get rid of it.

Others trade futures hoping to profit from changes in the price, never holding a contract when it comes due.¹ These are speculators, and the word isn't an insult here. A farmer who wants to sell forward needs someone willing to buy forward, and on any given day there may be no miller wanting exactly that amount. Speculators take the other side, and their trading helps make the market liquid enough to be useful for hedging.

Futures, forwards, and options

A forward is the same promise as a future, made privately. The difference shows when someone wants out: a person who buys a forward and then sells an identical forward to someone else has obligations under two contracts, one long and one short, and still depends on both counterparties.² Forwards and Swaps: An Introduction covers that private market.

Who oversees it

In the US, the Commodity Futures Trading Commission regulates commodity futures and other commodity derivatives. Anyone who trades futures with the public or gives advice about futures trading must be registered with the National Futures Association, which keeps a public record of registrations and disciplinary actions.¹ Checking it is the futures equivalent of the broker check in Who Regulates the Markets.

Key takeaways

• A futures contract obliges the buyer to buy and the seller to sell a fixed quantity at a fixed price on a future date.
• The exchange standardizes everything but the price. Contract value is price times contract size.
• Gains and losses are a straight line in both directions, with no premium and no built-in limit.
• The clearing house is the counterparty to every trade, so a position can be cancelled by an offsetting trade.
• Most contracts are offset before delivery. Delivery exists to keep futures and cash prices together.
• Hedgers use futures to remove a risk they have, and speculators take the other side.

Check your understanding

A trader buys two futures contracts on a commodity at $80 a unit. Each contract covers 1,000 units. The price falls to $74 and the trader closes the position. What's the result?

1. A loss of $6,000, since each unit fell by $6 and a contract is 1,000 units.
2. A loss of $12,000: $6 a unit on 2,000 units.
3. No loss, since the trader got out before the delivery date.

How does a buyer of a futures contract differ from a buyer of a call option on the same thing?

1. The futures buyer pays a larger premium for a longer-lasting right.
2. The futures buyer can walk away if the price falls before delivery.
3. The futures buyer is obliged to buy, and bears the whole fall in price.

What's next

Nobody pays $30,000 to control a wheat contract. Margin and Leverage in Futures covers the deposit they do pay, the daily settling of gains and losses, and what that does to the size of a mistake.