How Futures Contracts Work

A futures contract is a standardised, exchange traded agreement to buy or sell a set quantity of an asset at a price agreed today, for delivery or cash settlement on a specific future date. Futures exist on commodities such as crude oil, corn and gold, on financial assets such as stock indices, bonds and currencies, and on crypto. They let producers and consumers hedge prices and let traders take leveraged positions on almost any major market. The short introduction is in What Is a Future?; this lesson explains the mechanics in detail.

The key features#

Long and short#

• Long (buyer): agrees to buy at the futures price. Profits if the price rises.
• Short (seller): agrees to sell at the futures price. Profits if the price falls.

Going short is as easy as going long; there is no borrowing of the asset as with short selling stocks. See Short Selling.

A worked example#

Daily settlement#

Every trading day, the exchange sets a settlement price. Each account's open positions are revalued, and gains and losses move in cash between accounts through the clearing house. If your account falls below the maintenance margin, you receive a margin call and must add funds or reduce positions. This daily settlement is what makes futures safer for counterparties than private forward contracts. See Forwards vs Futures.

How futures prices relate to spot#

Futures prices are linked to the spot price by the cost of carry: financing, storage and any income from holding the asset.

futures price ≈ spot price × (1 + financing cost + storage cost - income) over the period

When futures trade above spot, the market is in contango; below spot, backwardation. At expiry, the futures price converges to the spot price. See Spot vs Futures, Contango and Backwardation.

How futures end#

• Offset: most traders close positions before expiry by taking the opposite trade.
• Roll: move the position to a later contract month. See Rolling Futures Contracts.
• Cash settlement: for index and some other contracts, the final gain or loss is paid in cash.
• Physical delivery: for many commodity and bond contracts, the actual asset changes hands. See Physical Delivery vs Cash Settlement.

Who uses futures#

Why traders like futures#

• Leverage and capital efficiency.
• Deep liquidity in major contracts, with tight spreads.
• Nearly 24 hour trading for many contracts.
• Easy shorting.
• Tax treatment in some countries; for example, US regulated futures are generally taxed under Section 1256 rules. Check local rules. See Trading Taxes and Capital Gains.

The risks#

• Leverage cuts both ways: small price moves create large gains or losses relative to margin.
• Losses can exceed the deposit.
• Margin calls can force selling at bad times.
• Gaps around news and weekends.
• Delivery risk if a physically settled contract is held too long.

Frequently asked questions#

How do futures contracts work?#

They are standardised agreements to buy or sell an asset at a set price on a future date, traded on exchanges with margin and daily settlement of gains and losses.

Can you lose more than you invest in futures?#

Yes. Because futures are leveraged, losses can exceed the margin deposited, and you are responsible for the shortfall.

Do I have to take delivery of a futures contract?#

Not if you close or roll the position before the delivery period. Many contracts are also cash settled.

Next, learn to read a contract's details in Contract Specifications.

Sources#

• CFTC, Basics of futures trading
• CME Group, Education