Guide to Futures Contracts
Learn how futures contracts work, from standardization and margin requirements to price discovery and hedging strategies in this comprehensive guide
What Are Futures Contracts?
A futures contract is a standardized agreement to buy or sell an underlying asset at a predetermined price on a set future date, traded on an exchange and guaranteed by a central clearinghouse. Unlike forward contracts which are customized bilateral agreements, futures are standardized in terms of quantity, quality, and delivery terms.
Daily marking-to-market and margining shift gains and losses each day and control counterparty risk, which is centralized at the clearinghouse rather than left bilaterally to the two traders. This institutional infrastructure makes futures one of the most liquid and accessible derivatives markets globally.
Key Characteristics
- •Standardization:Contract size, delivery dates, and quality specifications are predetermined by the exchange
- •Exchange Trading:All trades occur on regulated exchanges with transparent pricing
- •Central Clearing:A clearinghouse becomes the counterparty to all trades, eliminating bilateral credit risk
- •Daily Settlement:Profits and losses are settled daily through variation margin
Historical Development
Early Origins
Organized forward and futures-like trading dates to pre-industrial Japan. The Osaka–Dōjima rice market, officially sanctioned in 1730, employed standardized contracts and exchange procedures that scholars identify as the first active futures market. This market introduced many concepts still used today, including standardized contract terms and centralized trading venues.
Modern Exchange Era
In the United States, grain commerce and unreliable bespoke forwards prompted merchants to found the Chicago Board of Trade (CBOT) in 1848; by 1865 the CBOT had formalized standardized futures contracts to alleviate disputes over quality, delivery, and performance. This marked the beginning of modern futures trading in America.
Financial Futures Revolution
For more than a century, listed futures centered on commodities; the modern era of financial futures began in 1972 when the Chicago Mercantile Exchange's International Monetary Market (IMM) introduced currency futures, followed by interest-rate futures in 1975 and equity index futures in the early 1980s. This expansion transformed futures from an agricultural tool to a cornerstone of modern finance.
How Futures Markets Operate
Standardization and Clearing
Exchanges publish contract specifications (unit size, grade, delivery location/month, cash-settlement rules). Trades are novated to the clearinghouse, which becomes buyer to every seller and seller to every buyer.
Clearinghouses protect the market by requiring initial margin up front and variation margin (daily settlement) thereafter, liquidating positions that fail to meet calls. This system ensures market integrity even during extreme volatility.
Customer Fund Protection
In the U.S., customer margin posted to futures commission merchants (FCMs) must be segregated under CFTC Rule 17 C.F.R. §1.20, a foundational protection strengthened by post-crisis reforms. This segregation ensures customer funds are protected even if the FCM faces financial difficulties.
Margin Requirements
Academic work and policy studies show that margin levels respond to volatility and risk management needs, balancing protection against default with market participation costs.
Initial Margin
Upfront deposit required to open a position, typically a percentage of contract value
Variation Margin
Daily settlements of profits and losses based on market movements
Futures vs. Forward Contracts
Futures and forwards both lock future delivery prices, but daily settlement makes futures payoffs path-dependent with respect to interest rates. Understanding their differences is crucial for choosing the right hedging instrument.
Futures Contracts
- •Exchange-traded with standardized terms
- •Daily marking-to-market
- •Clearinghouse guarantees performance
- •High liquidity and transparent pricing
- •Lower counterparty risk
Forward Contracts
- •Over-the-counter with customizable terms
- •Settlement only at maturity
- •Bilateral credit risk
- •Less liquid, private negotiation
- •Higher counterparty risk
Pricing Theory and Term Structure
Classic "theory of storage" research explains that the basis (futures minus spot) reflects carrying costs (financing and storage) net of the convenience yield—the shadow benefit of holding physical inventory.
Market Conditions
Backwardation
When inventories are tight and the convenience yield is high, markets exhibit backwardation (near prices above deferred)
- • Near-term contracts trade at premium
- • High convenience yield from holding physical asset
- • Often seen in tight commodity markets
Contango
When inventories are ample and carrying costs dominate, contango prevails
- • Deferred contracts trade at premium
- • Storage and financing costs exceed convenience yield
- • Common in financial futures and abundant commodities
Pricing Components
Modern pricing contributions derive formal relations among commodity futures, interest rates, storage costs, and convenience yield and connect them to observed term structures.
Futures Price = Spot Price + Cost of Carry - Convenience Yield
Market Participants and Their Roles
Hedgers
The earliest formal models (and a vast empirical literature since) treat hedging as a portfolio problem: choose a futures position that minimizes the variance of the combined cash-and-futures exposure (the "minimum-variance hedge").
Ederington's classic study quantified hedging effectiveness by measuring risk reduction from optimal hedge ratios across new markets of the 1970s. Hedgers use futures to manage price risk in their underlying business operations.
- •Producers hedge future sales (short hedge)
- •Consumers hedge future purchases (long hedge)
- •Portfolio managers hedge market exposure
Speculators and Liquidity Providers
By taking the risks hedgers wish to shed, speculators earn risk premiums and supply liquidity. Studies of who actually trades in specific markets document distinct trading patterns across commercial hedgers, dealers, and other trader types.
- •Provide liquidity to hedgers
- •Take directional positions based on market views
- •Arbitrage price discrepancies across markets
Market Makers and Exchanges
Futures are not issued by operating companies the way bonds or stocks are; rather, exchanges list standardized contracts and clearinghouses guarantee performance. These institutions facilitate efficient price discovery and risk transfer.
Price Discovery Function
A core social function of futures exchanges is aggregating information into prices. Seminal and subsequent work shows that for many actively traded contracts, futures prices lead spot markets in assimilating information; where trading is thin, the leadership can be weaker.
Information Aggregation Process
Market Efficiency
Futures markets aggregate diverse information from thousands of participants into a single price signal, providing valuable benchmarks for physical markets and economic planning.
Price Leadership
Due to their liquidity and low transaction costs, futures often lead spot markets in reflecting new information, especially for commodities and financial instruments.
Transparency Benefits
Exchange-traded futures provide transparent, real-time pricing that helps producers, consumers, and policymakers make informed decisions.
Why Use Futures Instead of Other Instruments?
Capital Efficiency
Margins (not full notional) fund positions, freeing capital while constraining counterparty risk via central clearing and daily settlement. This leverage allows efficient portfolio management and hedging.
Ease of Shorting
Short exposures are as straightforward as long exposures, unlike many cash markets. Central clearing neutralizes locate/borrow frictions common in cash shorting.
Standardized Exposure
Liquid futures provide precise, transparent exposures (e.g., to benchmark commodities, rates, or equity indexes) that are tradable nearly around the clock and readily rolled across maturities.
Risk Management
Central counterparties mutualize (and monitor) risk, with segregation rules protecting customer collateral—an institutional advantage over bilateral OTC forwards.
Important Trade-offs
Futures users face basis risk (hedge mismatch if the contract does not perfectly track the exposure), roll yield (gains/losses from moving along the term structure), and liquidity variation across maturities and contracts.
- • Basis risk from standardized contracts not perfectly matching hedging needs
- • Roll costs when maintaining long-term positions
- • Daily margin requirements requiring active cash management
- • Limited customization compared to OTC derivatives
Historical Performance and Returns
At the portfolio level, fully collateralized commodity futures have historically delivered equity-like returns and diversification benefits over multi-decade samples, with return decomposition into spot, roll, and collateral components.
Return Components
Follow-up work extends and revisits these results. Futures returns can be decomposed into three primary sources:
Spot Return
Changes in the underlying commodity or asset price
Roll Yield
Gains or losses from rolling positions forward along the futures curve
Collateral Return
Interest earned on margin deposits and excess collateral
Disclaimer: Past performance is not a guarantee of future results. Futures trading involves substantial risk of loss and is not suitable for all investors.
Market Size and Activity
Exchange-traded derivatives markets represent one of the largest and most liquid segments of global financial markets, with activity spanning commodities, currencies, interest rates, and equity indices.
Market Characteristics
Trading Volume
Billions of contracts trade annually across global exchanges, with volumes sensitive to market volatility and economic conditions.
Product Diversity
Markets span agricultural commodities, energy products, metals, currencies, interest rates, and equity indices.
Global Reach
Major exchanges operate in Chicago, London, Shanghai, Singapore, and other financial centers, providing 24-hour market access.
Participant Base
Markets serve commercial hedgers, financial institutions, asset managers, and individual traders globally.
Practical Trading Considerations
Contract Specifications
Understanding contract specifications is essential for effective futures trading. Each contract defines:
- •Contract Size:The quantity of the underlying asset per contract
- •Tick Size:Minimum price movement and its dollar value
- •Delivery Terms:Physical delivery specifications or cash settlement procedures
- •Trading Hours:Regular and extended trading session times
Rolling Positions
Research ties margin policy to volatility and shows how changes in margin influence open interest, liquidity, and participation—costs that users can compare with ETFs, swaps, or forwards.
Traders maintaining long-term positions must "roll" contracts before expiration:
- • Close position in expiring contract
- • Simultaneously open position in later-dated contract
- • Consider roll yield impact on returns
- • Time rolls to minimize transaction costs
Execution and Order Types
Market Orders
Execute immediately at best available price
Limit Orders
Execute only at specified price or better
Stop Orders
Trigger market order when price reaches level
Spread Orders
Trade price difference between contracts
Risk Management in Futures Trading
Effective risk management is essential for successful futures trading, whether for hedging or speculation. Understanding and managing various risk factors can help protect capital and achieve trading objectives.
Types of Risk
Market Risk
The risk of losses from adverse price movements. This is the primary risk in futures trading and can be managed through position sizing, stop-losses, and diversification.
Basis Risk
For hedgers, the risk that the futures price may not move perfectly in line with the cash position being hedged. This can result from quality differences, location mismatches, or timing issues.
Liquidity Risk
The risk of not being able to enter or exit positions at desired prices, particularly in less liquid contracts or during market stress.
Operational Risk
Risks from system failures, human errors, or process breakdowns. Proper procedures and controls can minimize these risks.
Risk Management Tools
- •Position Limits:Set maximum exposure per trade and overall portfolio
- •Stop-Loss Orders:Automatically exit positions at predetermined loss levels
- •Diversification:Spread risk across different markets and strategies
- •
Important Risk Warning
Futures trading involves substantial risk of loss and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before trading futures, carefully consider your financial situation, experience level, and risk tolerance.
Conclusion
Futures contracts arose to solve very practical problems—assuring performance on delayed delivery trades, standardizing terms, and enabling robust price discovery. From their origins in agricultural markets to their current role in global finance, futures have evolved into sophisticated instruments serving diverse economic needs.
Their modern architecture—standardized listings, central clearing, and margining—yields uniquely capital-efficient and transparent risk transfer that serves hedgers, speculators, and the broader economy. This infrastructure has proven resilient through numerous market cycles and crises.
Key Takeaways
- •Futures provide standardized, exchange-traded exposure with central clearing
- •Daily marking-to-market and margin requirements manage counterparty risk
- •Markets serve both hedgers managing business risk and speculators providing liquidity
- •Price discovery function provides valuable economic information
- •Capital efficiency through leverage makes futures attractive for portfolio management
Theory (storage and convenience yield), empirics (basis behavior, hedging effectiveness), and institutional design (clearing, segregation) together explain why futures remain indispensable—and why, for many exposures, investors may rationally prefer them to other instruments.
Important Disclaimer
This content is for educational and informational purposes only and does not constitute financial, investment, tax, or legal advice. The author is not a registered investment advisor, certified financial planner, or certified public accountant. Always consult with qualified professionals before making any financial decisions. Past performance does not guarantee future results. Investing involves risk, including potential loss of principal.
The information provided here is based on the author's opinions and experience. Your financial situation is unique, and you should consider your own circumstances before making any financial decisions.
Share This Article
Sources & References
Click on any cited text in the article to jump to its source.