What Is Futures?
Futures are contracts obligating the buyer to purchase an asset at a predetermined price on a future date. Learn how futures work, types, and risks.
Definition
A futures contract is a legally binding agreement to buy or sell a specific asset at a predetermined price on a set future date. Unlike options (which give you the right but not the obligation), futures obligate both the buyer and seller to complete the transaction. Futures trade on exchanges like the Chicago Mercantile Exchange (CME).
Futures contracts exist for commodities (oil, gold, corn, wheat), financial instruments (S&P 500, Treasury bonds), currencies, and more. Each contract specifies the quantity, quality, and delivery date. Most futures traders close their positions before expiration rather than taking physical delivery -- no one wants 40,000 pounds of cattle showing up at their brokerage.
Futures use leverage, meaning you only need to deposit a small percentage (the margin, typically 5-15%) of the contract's full value. This leverage amplifies both gains and losses enormously. A 5% move in the underlying asset can produce a 50-100% gain or loss on the margin deposited.
Real-World Example
An oil futures contract on the CME represents 1,000 barrels of crude oil. If oil is at $80 per barrel, one contract controls $80,000 worth of oil, but the margin requirement might be only $6,000. If oil rises 5% to $84, you make $4,000 on a $6,000 margin deposit -- a 67% return. If oil drops 5% to $76, you lose $4,000 -- a 67% loss. If oil drops 8% to $73.60, you have lost your entire $6,000 margin deposit and may owe additional money.
Why It Matters
Futures markets serve a critical economic function: they allow farmers, miners, airlines, and manufacturers to hedge against price fluctuations. A wheat farmer can lock in a selling price months before harvest, reducing income uncertainty. For individual investors, futures are an advanced speculative instrument with extreme leverage and risk. Understanding futures helps you appreciate how commodity prices are determined and why oil, gold, and grain prices move the way they do.
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Frequently Asked Questions
What is the difference between futures and options?
Futures obligate both parties to complete the transaction. Options give the buyer the right (but not the obligation) to transact. Futures have unlimited risk in both directions; buying options limits risk to the premium paid.
Can individual investors trade futures?
Yes, through brokerages that offer futures trading. However, futures are highly leveraged and risky. Most financial advisors recommend that only experienced traders with significant capital and risk management skills trade futures.
What are stock index futures?
Futures contracts based on stock market indexes like the S&P 500, Nasdaq-100, or Dow Jones. They are used by institutional investors to hedge portfolio risk and by speculators to bet on market direction. S&P 500 futures trading outside market hours influences the next day's opening prices.
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