What it means
Every futures contract specifies four things: the commodity and its quality grade, the quantity per contract, the delivery month, and the delivery point. One crude oil contract, for example, covers 1,000 barrels, and one contract is identical to every other contract for the same month, which is what allows a deep and liquid market to exist.
The business reason for caring is price certainty. A food manufacturer, a haulage firm or a metal fabricator cannot easily reprice its own products every week, so a sudden jump in the cost of grain, diesel or aluminium eats straight into margin.
Fixing the input price months ahead lets the finance team budget with confidence rather than hoping the market behaves. Mechanically, you do not pay the full value of the contract up front.
You post initial margin, a good-faith deposit that is typically a single-digit percentage of the contract's face value, and the exchange then settles gains and losses in cash every day in a process called marking to market. If the market moves against you, you receive a margin call and must top the account up, which is why a hedging programme needs its own cash buffer.
Most commercial hedgers never take delivery of the physical commodity. They close the futures position shortly before expiry by taking the opposite trade, then buy or sell the actual goods through their normal supplier or customer, with the futures profit or loss cancelling most of the movement in the physical price.
The main nuance is basis risk, the gap between the exchange-traded reference price and the price you actually pay locally. A futures contract for a benchmark grade delivered to a distant hub will not track your regional supplier's invoice perfectly, so hedging reduces price risk rather than eliminating it entirely.
In practice
Real-world examples.
Example
A speciality coffee roaster commits to a fixed wholesale price list for the next twelve months. To protect that commitment it buys arabica futures covering roughly 70% of its expected green bean purchases, so a bad harvest in a major growing region cannot wipe out the year's gross margin.
Example
A copper wire manufacturer wins a large infrastructure contract priced today but delivered over eighteen months. Its treasury team buys copper futures matched to the delivery schedule, converting an open-ended metal exposure into a known input cost the bid team can rely on.
Example
A grain farmer sells corn futures in spring for the autumn harvest month, fixing a sale price before the crop is even in the ground. If prices fall by harvest, the futures gain makes up most of the shortfall on the physical crop; if prices rise, the futures loss offsets the better cash price.
Formula
Calculation
Notional value = contract size x futures price x number of contracts. Gain or loss on the position = (exit price - entry price) x contract size x number of contracts.
A regional fuel distributor expects to buy 10,000 barrels of crude-linked product in three months and wants to fix the cost at today's price of $80 per barrel. It buys 10 crude oil futures contracts of 1,000 barrels each. Notional value = 1,000 x $80 x 10 = $800,000. Initial margin is $6,000 per contract, so the distributor posts 10 x $6,000 = $60,000.
Three months later the price has risen to $86. The futures gain = ($86 - $80) x 1,000 x 10 = $6 x 10,000 = $60,000. Meanwhile the physical purchase now costs 10,000 x $86 = $860,000. Subtracting the $60,000 futures gain gives a net cost of $800,000, which is exactly $80 per barrel, the price the distributor set out to lock in.Case study
Seen in the real world.
Northwind Rolling Mills is an illustrative, entirely fictional aluminium processor with annual metal purchases of about 12,000 tonnes. For years it priced customer contracts on a cost-plus basis and passed metal moves straight through, until its three largest customers demanded fixed twelve-month pricing as a condition of renewal.
The finance director agreed, but only alongside a hedging policy. Northwind began buying aluminium futures to cover 80% of the metal embedded in fixed-price orders, leaving the remaining 20% floating so the mill could still benefit if prices fell. The board set a separate $1,500,000 margin facility so that daily settlement calls could never compete with working capital.
In the first year metal prices rose sharply. The physical purchase bill went up, the futures account produced an offsetting gain, and the reported gross margin on the fixed-price contracts moved by less than one percentage point. The lesson the illustrative board took away was that futures did not make Northwind money; they made its margin predictable enough to sign the contracts in the first place.
Watch out
Common mistakes.
- Treating a hedge as an investment and judging it by whether it made a profit. A hedge that loses money because prices fell has done its job, because the physical purchase became cheaper by a matching amount.
- Forgetting that margin calls need cash. Firms have been forced to abandon sound hedges midway because they did not arrange a credit line for daily settlement before the market moved.
- Assuming the futures price is a forecast. It is the price at which buyers and sellers will transact today for later delivery, not a prediction of where the market will actually be.
Questions
People also ask.
Do I have to take delivery of the physical commodity?
Almost never in practice, because commercial hedgers close the position before expiry and buy the goods through their usual supply chain.
How is a futures contract different from a forward?
A futures contract is exchange-traded, standardised and settled daily through a clearing house, while a forward is a private, customised deal between two parties with credit risk on both sides.
Can a small business use futures?
It can, but contract sizes are large and margin management takes discipline, so many smaller buyers instead use fixed-price supplier agreements or ask their bank about smaller over-the-counter alternatives.
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