What it means
A futures contract fixes the terms of a trade today for delivery later. The asset can be a commodity such as oil, wheat or gold, a financial instrument such as a stock index or a government bond, or a currency.
Because each contract has a standard size, quality and expiry date, it can be traded freely between strangers. The exchange's clearing house stands between buyer and seller, so each side faces the clearing house instead of the other party.
To make this safe, both sides post an initial margin, and gains and losses are settled in cash every day through a process called marking to market. If losses eat into the margin, the trader receives a margin call and has to add more money quickly.
Hedgers and speculators use the market for different reasons. An airline might buy fuel futures to fix part of its future fuel bill, while a farmer might sell wheat futures to lock in a price ahead of harvest.
Speculators take the opposite side of these trades, hoping to profit from price changes and providing liquidity in the process. Most contracts never reach delivery.
Traders usually close their positions before expiry by taking an equal and opposite trade, and many contracts, such as stock index futures, are settled in cash instead of physical delivery. The profit or loss is the difference between the entry and exit prices, multiplied by the contract size.
The nuance for non-specialists is leverage. Because only a fraction of the contract value is posted as margin, a small price move can wipe out a large share of the deposit.
Finance teams that use futures to hedge also need to think about how the gains and losses are reported, since hedge accounting rules decide whether results appear in profit straight away or later.
In practice
Real-world examples.
Example
A regional airline expects to burn a large amount of jet fuel next year. Its treasurer buys fuel-related futures to fix the cost of about half of the expected volume. If prices rise, the gain on the futures offsets some of the higher fuel bill.
Example
A wheat farmer sells futures contracts three months before harvest to lock in a price that covers his costs and a reasonable profit. When the harvest arrives, prices have fallen, but the gain on his short futures position makes up much of the lower sales price. His income for the year is steadier as a result.
Example
A fund manager holding a $10 million share portfolio expects a short-term fall in the market. Instead of selling the shares and paying transaction costs, she sells stock index futures worth about $10 million. The futures gain if the market falls, which offsets the drop in her portfolio.
Formula
Calculation
Profit or loss on a long position = (exit price - entry price) x contract size x number of contracts
For a short position, reverse the sign: (entry price - exit price) x contract size x number of contracts.
Suppose a trader buys 2 crude oil futures contracts at $70.00 per barrel, where each contract covers 1,000 barrels. The trader later closes the position at $73.50 per barrel. Profit = (73.50 - 70.00) x 1,000 x 2 = 3.50 x 1,000 x 2 = $7,000. If the price had instead fallen to $68.00, the loss would be (68.00 - 70.00) x 1,000 x 2 = -$4,000.Case study
Seen in the real world.
Sunrise Bakeries is an illustrative, fictional company that buys large quantities of wheat flour. After a year in which a sudden price spike squeezed margins, the finance director proposed a hedging policy using wheat futures.
The policy allowed the treasury team to hedge up to 60% of expected purchases over the next six months, with a strict limit on the margin cash that could be committed. A risk committee reviewed positions monthly, and the accountants documented the hedge relationship so the gains and losses would be matched with the flour purchases.
In the illustrative outcome, wheat prices rose again, the futures gains offset a good part of the extra flour cost, and margins stayed within the budget range. The finance director noted that the hedge had not made the company a profit; it had simply made its costs more predictable.
Watch out
Common mistakes.
- Treating the margin deposit as the maximum possible loss, when losses on a futures position can exceed the initial margin.
- Using futures to speculate and calling it hedging, which can create large unplanned losses and accounting difficulties.
- Ignoring the cash needed for daily margin calls, so that a profitable hedge in the long run still causes a short-term cash crunch.
Questions
People also ask.
What is the difference between futures and forwards?
Futures are standardised, traded on an exchange and settled daily through a clearing house, while forwards are private, tailor-made agreements between two parties with settlement usually at the end.
Do I have to take delivery of the asset?
Not usually, since most traders close their positions before expiry and many contracts settle in cash.
What is a margin call?
It is a demand from the broker to add more money to your account because losses have reduced your balance below the required level.
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