A futures contract (generally a short form of "commodity futures contract") is a legally binding agreement transacted on a futures exchange to make or take delivery of a specified commodity or other asset, at a fixed date in the future, at a price agreed upon between buyer and seller at the time of the trade. The contract may be bought and sold either for risk management (hedging) or in order to profit from a correct prediction of movement in the market (speculation). This contrasts with options trading, in which the option buyer may choose whether or not to exercise the option by the options exercise date.
VIDEO: What is a Futures Contract?
An animated video from MarketsWiki explaining the basics of futures contracts.
Specifications of a Futures Contract
The futures contract itself specifies exactly what is being bought and sold, and the manner in which the transaction takes place. A futures contract defines:
- The standard, fixed quantity of the commodity being traded (e.g, 5,000 bushels of corn, 1,000 barrels of heating oil, 12,500,000 Japanese yen, etc.)
- The quality grade of the commodity (this is not relevant for all commodities; national currencies, for example, do not have varying degrees of quality)
- Rules for price adjustments for commodities delivered that are either above or below the specified quality grade
- The minimum price fluctuation for the contract (e.g., 1/4 cent per bushel)
- The day on which the actual commodity is to be delivered, and the manner in which the buyer will take possession of the commodity, if not offset before expiration of the futures contract.
- The unit pricing of the commodity (e.g. cents per bushel, or dollars per barrel)
- The hours and days during which the contract will be available for trade at the exchange.
The concept of the futures contract has agricultural roots. Farmers raised livestock and grew crops and other agricultural commodities and brought them to market to sell to commercial entities.
Substantial risk existed on both sides of that transaction and process. Farmers arriving late to market with their goods could find that the buyers had already completed their purchases with others, and there was no one remaining to buy the crops. Buyers were vulnerable to the delivery of substandard products or no products at all if the growing season had failed to produce enough of the commodity.
Buyers needed a way to ensure that the quantity and quality of commodity they needed would be available when they needed it. Farmers needed a way to know that a glut of available crops would not put them out of business.
The price of any valued commodity rises and falls over time. Myriad factors affect the perceived value of everything. Weather patterns, the global economy, problems at storage facilities, the occasional bout of the madness of crowds - there is an endless variation of circumstances that change prices, and all of it is at some level unpredictable. Further, the degree and manner in which prices respond to these factors is also difficult to predict.
In this environment, suppliers and buyers of commodities are faced with the unpleasant reality that regardless of the price right now for the goods they buy and sell, there is no way to know with certainty what the price will be next year, or even next month. What is certain, is that both buyer and seller need a way to lock in a price to realize an acceptable profit now, next month, next year and beyond.
The development of the futures contract created an effective way to control this risk. A futures contract is a method by which a buyer and a seller agree to complete a contractual transaction for a commodity or financial instrument in a specific future "contract month," for a specific price. For example, a farmer and cereal maker could create an agreement to buy 5,000 bushels of corn for $3.00 a bushel, with the understanding that the corn would be delivered to the cereal maker at the end of next April. (In reality, of course, in futures, the farmer and cereal maker do not know who they are transacting business with, as it is anonymous; thus the farmer enters the futures markets, as does the cereal maker, and they transact business based on future price, not based on market user.)
With the contract in place, both buyer and seller have an exact understanding of the total sale price. No matter what might happen to the cash price of the commodity by next April, the contract enforces the original, agreed-upon price.
The exact market value of a futures contract at any moment is determined by factors both subjective and quantitative. The futures price for a commodity depends in part on the cost to produce and store the goods, current supply and demand, and anticipated supply and demand into the future. Value is a fluid and changing thing. There is no "one true price" for a bushel of corn; consequently, there is no one true price for a contract that sells a bushel of corn six, nine or 12 months from now. Price must be "discovered," or agreed upon, by finding the meeting point between seller and buyer.
What Makes for a Good Futures Contract?
Whatever the item underlying the futures contract, every market needs certain ingredients to flourish. These include:
- Risk-shifting potential. The contract must provide the ability for those with price risk in the underlying item to shift that risk to a market participant willing to accept it.
- Price volatility. The price of the underlying item must change enough to warrant the need for shifting price risk.
- Cash market competition. The underlying cash (or physicals) market must be broad enough to allow for healthy competition, which creates a need to manage price risk and decreases the likelihood of market corners, squeezes or manipulation.
- Liquidity. Active trading is needed so that sizable orders can be executed rapidly and inexpensively. New futures products often take a while to gain traction to be what is considered by market participants liquid enough to take part in the market. This is normal.
- Standardized underlying entity. The product underlying the futures contract must be standardized and/or capable of being graded so that it is clear what is being bought and sold.
Trading the Contract
Contracts are traded at the futures exchange that offers them, according to the rules of the exchange and the specification of the contract.
Hedge trading is done by people and companies that have an actual interest in the commodity itself. Farmers buy and sell futures contracts as a way to control the price at which they'll sell their crops. Produce companies use futures contracts to control the risk of skyrocketing future prices. International corporations can buy and sell currency and interest rate futures contracts as a way to hedge against unfavorable exchange rates and other cross-country economic factors.
Speculators are futures traders who do not have a direct interest in the actual commodity. Speculators take part in the futures markets to buy and sell contracts in the hope of simply profiting in the changing price. A trader believing that crops in the central USA will be damaged by coming weather can buy grain contracts, and sell them for a profit if the price of grain does rise.
Speculative traders provide an important boost in liquidity for all participants. The fewer traders in a market, the harder (and generally less favorably priced) it is to buy and sell contracts. Speculators provide hedgers with more potential trading partners, and generally provide more stability in the market's operation.
That speculators don't have an interest in the actual commodity can often cause confusion for investors learning about the futures markets. How can someone sell a commodity that they don't produce, and isn't a buyer obligated to assume responsibility for boxcars full of cattle, or suitcases full of money?
Up until the date for delivery nears, it simply doesn't matter whether the seller actually has the goods because what is being bought or sold is the future promise, the contract, not the actual commodity. A promise to deliver grain in six months can be made by anyone. Similarly, the buyer isn't buying a giant warehouse freezer full of orange juice concentrate; rather, they are promising to buy it six months from now.
A contract to buy can be offset by selling it to somebody else. An obligation to sell a commodity can be offset by buying a contract from someone else. A trader who buys and then sells the contract is free of obligation.
As the delivery date becomes imminent, the exchanges do require participants to prove their ability to actually buy and sell, for those commodities that are actually delivered.
Cash-Settled vs. Physical Delivery
Many modern futures contracts do not fit the historical model of "goods in boxes." Electricity futures, stock index futures, interest rate futures, weather futures, carbon emission futures and others are markets that have an important function but deal in "commodities" that are seemingly elusive or conceptual in nature. Such commodities cannot practicably be delivered to an exchange, graded and distributed to buyers.
Also, in modern times many hedging traders that have an interest in the commodity do not want to take delivery of the physical product from a central warehouse in Chicago, New York or Thailand; yet they still need to keep control of their risk related to the commodity.
To address both of those situations, exchanges since the early 1980s began to move from physically settled futures contracts to "cash-settled" futures contracts. Eurodollar futures in 1981 were the first to establish use of cash settlement.
In this model, at the end of the last day of trading the settlement price of the contract is used to determine the full value of the contract. The seller of the contract pays the buyer the cash value of the contract, and the deal is considered complete.
Sellers of the commodity can then sell it on the cash market locally, and the futures contract will offset approximately the difference between the cash price and the original price for the contract. The same mechanism exists for the buyers, who receive cash from the contract, and buy the commodity on the cash market.