What it means
A futures contract fixes the quantity, the quality and the delivery month in advance, leaving the price as the only thing the two sides negotiate. That standardisation is what makes the contract tradeable, because any buyer can be matched with any seller through the exchange without either party vetting the other.
The exchange's clearing house sits in the middle of every trade and becomes the legal counterparty to both sides, which removes the worry that the person on the other end will walk away. In return for that guarantee, both sides post initial margin, a good-faith deposit that is usually a small fraction of the contract's face value.
Positions are marked to market every day, meaning gains are credited to your account in cash and losses are debited before the next session opens. If losses eat into the deposit, the broker issues a margin call and you must top the account back up or have the position closed out for you.
For most businesses the appeal is budget certainty rather than profit. A miller who fixes wheat costs for the next six months can quote prices to supermarkets with confidence, and if wheat later falls it has simply lost a windfall it never budgeted for in the first place.
The main nuance is that hedges are rarely perfect. Exchange contracts come in fixed sizes and fixed delivery months, so the quantity or timing you need may not match exactly, and the gap between the futures price and your local cash price, known as the basis, can move against you.
Futures are often confused with forwards, which do the same economic job privately between two parties, with no exchange, no daily cash settlement and no standard contract size. Forwards can be tailored precisely, but they carry the credit risk of the counterparty and are much harder to exit before maturity.
In practice
Real-world examples.
Example
A copper miner sells futures covering six months of planned output at $4.20 per pound to protect its revenue budget. When the copper price later slides to $3.80, the gain on the futures makes up most of the shortfall on the metal it physically sells. The finance director keeps the annual plan intact instead of reforecasting mid-year.
Example
A pension fund receives a large cash contribution and wants equity exposure immediately. It buys stock index futures within minutes rather than spending two weeks buying hundreds of individual shares, then unwinds the futures as the physical portfolio is built. The fund captures the market return during the gap instead of sitting in cash.
Example
A chocolate manufacturer fixes cocoa costs for the coming season using futures, then sets its wholesale price list for the year. Cocoa prices rise sharply after a poor harvest, but the company's input cost is already locked, so its gross margin holds while competitors reprice mid-season.
Think of it
“Futures contract is an obligation to trade later-you must buy or sell at the agreed price.
Formula
Calculation
Contract value = contract size x price per unit x number of contracts. Profit or loss on a long (buying) position = (exit price - entry price) x contract size x number of contracts.
A fuel distributor expects to buy 5,000 barrels of crude oil in three months and wants to fix the cost now. It buys 5 crude oil futures contracts, each covering 1,000 barrels, at $70.00 per barrel. The face value of the position is 1,000 x $70.00 x 5 = $350,000, but the exchange requires initial margin of only $6,000 per contract, so the distributor posts 5 x $6,000 = $30,000 in cash.
Three months later crude has risen to $74.00. The gain on the futures is ($74.00 - $70.00) x 1,000 x 5 = $20,000, which is a return of $20,000 / $30,000 = 66.7% on the margin posted. The distributor now buys the physical oil at $74.00 per barrel, costing 5,000 x $74.00 = $370,000, and the $20,000 futures gain brings the net cost back to $350,000, exactly the $70.00 per barrel it wanted. Had oil instead fallen to $66.00, the futures position would have lost $20,000 while the physical purchase cost only 5,000 x $66.00 = $330,000, again netting to $350,000.Case study
Seen in the real world.
Northwind Grain Co is an illustrative, entirely fictional flour miller that supplies bakery chains on twelve-month fixed-price contracts. In one particularly volatile year its buying team watched wheat swing by more than 30% between spring and autumn, which made fixed-price customer contracts a serious risk to the year's profit.
The treasurer began hedging roughly 70% of expected annual wheat volume with exchange-traded futures, rolling the positions forward as delivery months approached. Wheat rose sharply that summer, and although the physical grain cost far more than budget, the futures gains offset most of the increase and the gross margin landed within one percentage point of plan.
The lesson the fictional company drew was less about trading skill than about discipline. Because only 70% of volume was hedged, a portion still moved with the market, and the board learned to judge the hedging programme by the stability of margins rather than by whether the futures themselves made money.
Watch out
Common mistakes.
- Judging a hedge by whether the futures position made a profit. A hedge that loses money while the physical purchase gets cheaper has done exactly its job, which is to remove the swing in either direction.
- Treating the initial margin as the maximum you can lose. Margin is only a deposit, and losses on a futures position can exceed it, which is why margin calls exist.
- Assuming a futures hedge covers you perfectly. Fixed contract sizes, fixed delivery months and local price differences all leave residual basis risk that no exchange contract can remove.
Questions
People also ask.
Do I have to take delivery of the physical goods?
Almost never in practice, because the great majority of contracts are closed out or cash settled before the delivery period begins.
How much money do I need to open a futures position?
Far less than the face value, since initial margin is typically a single-digit percentage of contract value, which is precisely why futures magnify both gains and losses.
Are futures the same as options?
No, because a futures contract obliges both sides to complete the trade, while an option gives the holder a choice and the writer an obligation.
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