Table Of Content
What Are Futures Contracts and How Do They Work?
Futures contracts are legal agreements to buy or sell an asset at a predetermined price on a specific future date.
These contracts are standardized and traded on regulated exchanges, making them accessible to both institutional and individual investors.
For example, a wheat farmer might sell a futures contract in May to lock in a price for their crop in September, helping manage the risk of falling prices. Meanwhile, a bakery might buy that contract to secure its ingredient costs.
Do Investors Really Need to Buy the Commodity When the Contract Expires?
When a futures contract expires, one of two things typically happens: physical delivery or cash settlement. However, most retail investors don’t take delivery of the commodity—they usually close or roll over their positions before the expiration date.
For example, if a trader holds a crude oil futures contract but doesn’t want physical barrels of oil, they’ll sell the contract before it expires. This is common practice, especially for speculators.
On the other hand, certain institutional participants like manufacturers or food producers might allow the contract to settle physically, receiving or delivering the commodity as agreed.
Some contracts, like index futures (e.g., S&P 500), are cash-settled automatically.
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Cash-Settled Contracts
These contracts don’t involve delivery of the actual asset.
Instead, the value is settled in cash based on the difference between the contract price and the market price at expiration.
Example Contracts | Underlying Asset | Common Use Cases |
|---|---|---|
S&P 500 Futures (ES) | Stock Index | Hedging or speculating on overall market |
Eurodollar Futures | Interest rates | Rate hedging for institutions |
Volatility Index (VIX) | Market volatility | Speculating on market fear/volatility |
Bitcoin Futures (CME) | Cryptocurrency | Gaining exposure without owning Bitcoin |
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Physically-Settled Contracts
These require actual delivery of the asset unless the position is closed before expiration. Delivery is handled through a regulated process, but retail investors typically avoid this by exiting early.
Example Contracts | Underlying Asset | Common Use Cases |
|---|---|---|
Crude Oil (CL) | 1,000 barrels of oil | Hedging for refiners and oil producers |
Gold (GC) | 100 troy ounces of gold | Hedging or taking delivery of precious metals |
Corn, Soybeans, Wheat | Agricultural commodities | Used by farmers and food producers |
Live Cattle, Lean Hogs | Livestock | For meat processors and distributors |
Whether a contract is cash- or physically settled depends on how it is structured by the exchange.
For example, CME Bitcoin futures are cash-settled, while ICE offers physically delivered Bitcoin contracts.
You can verify settlement types on the contract specs page of the exchange, such as CME Group.
Types of Futures: Commodities, Index, Currency & Bond Futures
Futures contracts cover a wide range of markets, allowing traders and businesses to hedge or speculate in different sectors.
Commodity Futures: These include contracts on physical goods like crude oil, gold, corn, or natural gas. For instance, airlines often use oil futures to lock in fuel prices and manage volatility.
Index Futures: Linked to financial indices such as the S&P 500, these allow investors to hedge or gain exposure to the broader market. A fund manager might short index futures during uncertain markets to protect a portfolio’s value.
Currency Futures: Used to manage foreign exchange risk, these contracts help multinational businesses lock in currency rates. An American company expecting payment in euros can buy euro futures to protect against unfavorable exchange rate shifts.
Bond Futures: These represent contracts on government bonds like U.S. Treasuries. Traders often use them to speculate on or hedge against changes in interest rates.
- Crypto Futures: Gained traction in recent years, investors and traders can now purchase Bitcoin and Ethereum futures.
Each type offers unique tools depending on whether the goal is risk management or speculative gain.
How Futures Prices Are Determined
Futures prices are primarily driven by the spot price of the underlying asset plus or minus the “cost of carry.” This includes storage costs, interest rates, and any income (like dividends) associated with holding the asset.
For example, if gold is trading at $2,000 today and storing it costs $20 over a three-month period, a futures contract may be priced at $2,020.
Supply and demand in the futures market also influence prices—heavy demand for crude oil futures during geopolitical tensions might push prices above the expected carry-adjusted level.
Additionally, expectations of future economic conditions can cause futures prices to diverge from spot prices.
How Investors Use Futures: Key Strategies
Futures contracts give investors flexible ways to manage risk or pursue profit in changing markets. Here are some common strategies:
Hedging: Businesses use futures to protect against price swings. For example, a corn farmer may sell corn futures before harvest to lock in prices and secure predictable revenue.
Speculation: Traders aim to profit from short-term price movements without owning the asset. A speculator might buy oil futures expecting higher prices due to supply cuts.
Arbitrage: Some investors exploit price differences between markets. If gold futures on one exchange are cheaper than on another, arbitragers can profit from the price gap.
Portfolio Diversification: Investing in futures on commodities, currencies, or indices allows investors to gain exposure to sectors that are not easily accessed through traditional stocks or ETFs.
Futures trading is fast-paced and capital-efficient, but it also comes with higher risk due to leverage.
How Futures Differ from Options and Stocks
Futures contracts, options, and stocks are all traded on exchanges, but they serve very different purposes. Stocks represent ownership in a company and can be held indefinitely.
Options give the right—but not the obligation—to buy or sell an asset. Futures, however, are binding contracts with a set expiration date, requiring buyers and sellers to fulfill the terms unless the position is closed beforehand.
For example, a futures trader is obligated to either buy or sell the asset at the contract’s expiration, unlike an options holder who can choose not to exercise the contract.
Feature | Futures | Options | Stocks |
|---|---|---|---|
Obligation | Yes | No (holder has a choice) | No (ownership stake) |
Expiration | Yes | Yes | No expiration |
Ownership | No | No | Yes |
Use Case | Hedging, speculation | Hedging, speculation | Long-term investment |
FAQ
Profits and losses are marked to market daily, meaning gains or losses are realized at the end of each trading day. This impacts your margin balance in real time.
Yes, futures trading is regulated in the U.S. by the Commodity Futures Trading Commission (CFTC) and enforced through exchanges like the CME.
Mini and micro futures are smaller versions of standard contracts, allowing traders to take smaller positions. They’re ideal for retail traders seeking lower risk exposure.
Yes, but you must be prepared for physical delivery or final cash settlement depending on the contract. Most traders exit positions before expiration.
Futures prices include carrying costs and expectations about future supply and demand. As expiration nears, futures and spot prices usually converge.
The capital needed depends on the margin requirement of the specific contract. Micro futures allow entry with a few hundred dollars, while larger contracts need thousands.
If you fail to meet a margin call, your broker may automatically liquidate your position to limit risk. This can lock in losses and impact your account.
Certain futures, especially commodities like gold and oil, can serve as inflation hedges. Investors use them to maintain purchasing power during inflationary periods.
