What a futures contract actually is

A futures contract is an agreement to buy or sell something at a set price on a set date in the future. You are not buying the thing itself right now — you are locking in a price today for a transaction that will happen later, usually a few months away.

The "something" is usually a commodity like wheat, oil, or gold; a financial instrument like a stock index or Treasury bond; or a currency. The contract specifies exactly how much, at what price, and on what date the exchange will happen. Both the buyer and the seller are legally bound to complete the trade when that date arrives, unless they close the contract early by selling it to someone else.

Futures trade on exchanges — the Chicago Mercantile Exchange (CME) is the largest in the United States. These are not over-the-counter deals between two people; they are standardized contracts with rules, margin requirements, and daily price settlement.

Key Takeaways

  • A futures contract locks in a price today for something you will buy or sell months from now, and both sides are legally required to complete the trade unless they exit early.
  • Futures are traded on regulated exchanges like the CME, not between individuals, and require a margin deposit — usually 5 to 15 percent of the contract's total value.
  • The price of a futures contract changes every trading day, and your account is marked to market daily, meaning gains and losses are calculated and settled each day.
  • Farmers, oil refineries, and other businesses use futures to lock in prices and reduce risk; traders use them to bet on price movement with leverage.
  • Futures are riskier than buying the underlying asset outright because you control a large position with a small deposit, so losses can exceed your initial investment.

Why people enter futures contracts

There are two main reasons: hedging and speculation.

Hedging means reducing risk. A wheat farmer knows in spring that he will harvest grain in fall, but he does not know what the price will be then. He can sell a futures contract now at a price he finds acceptable. If prices fall by harvest time, he is protected — he already locked in his price. If prices rise, he misses out on the gain, but he avoided the risk of a price collapse. A refinery that needs oil in three months can buy a futures contract now to lock in the cost, protecting itself against a price spike.

Speculation means betting on price movement to make a profit. A trader who believes oil prices will rise can buy an oil futures contract with a small margin deposit. If the price goes up, the contract gains value and the trader can sell it for a profit. If the price falls, the trader loses money. The leverage — controlling a large contract with a small deposit — means both gains and losses are magnified.

How margin and leverage work in futures

You do not pay the full value of a futures contract upfront. Instead, you deposit margin — a percentage of the contract's value, typically 5 to 15 percent depending on the commodity and the exchange. This margin is a good-faith deposit that shows you can cover losses.

If you buy a crude oil futures contract worth $100,000 and the margin requirement is 10 percent, you deposit $10,000. You now control $100,000 worth of oil with $10,000 of your money. This is leverage: a small move in the price creates a large percentage gain or loss on your deposit. If oil rises 5 percent, your $10,000 deposit gains $5,000 — a 50 percent return. If oil falls 5 percent, you lose $5,000 — a 50 percent loss on your deposit.

Your account is marked to market every day, meaning the exchange calculates your gain or loss based on the closing price and settles it when ready. If you lose money, the exchange withdraws the loss from your account. If your account balance falls below the maintenance margin (usually lower than the initial margin), you must deposit more money or the exchange will close your position automatically.

The daily settlement process

Every trading day, the exchange looks at the closing price of your futures contract and compares it to the price you entered at. The difference is your daily profit or loss, and it is transferred in or out of your account that same day.

Say you bought a gold futures contract at $2,000 per ounce and the next day it closes at $2,010. You have a $10-per-ounce gain. A standard gold contract is 100 ounces, so you gain $1,000. The exchange deposits that into your account. The next day, if gold closes at $1,995, you lose $15 per ounce, or $1,500 on the contract. The exchange withdraws that from your account.

This daily settlement is different from owning a stock, where gains and losses are only realized when you sell. With futures, you see the gain or loss every single day, and you must have enough cash in your account to cover daily losses. If you cannot cover a loss, your broker will close your position without asking.

How futures contracts expire and settle

Every futures contract has an expiration date — the last day you can trade it and the day the final settlement happens. For a December crude oil contract, expiration might be the third Tuesday of December. As that date approaches, the contract becomes less liquid (fewer buyers and sellers) and the price converges toward the actual spot price of oil.

On expiration day, one of two things happens. For physical commodities like oil or wheat, the contract can settle by physical delivery — the seller actually delivers the commodity to the buyer. Most traders do not want to take delivery of 1,000 barrels of oil, so they close their position before expiration by selling the contract to someone else.

For financial futures like stock index contracts, settlement is usually cash settlement — the exchange calculates the final difference between the contract price and the spot price, and money changes hands instead of the underlying asset. Either way, if you still hold the contract on expiration day, the position is closed and you cannot trade it anymore.

The risks specific to futures trading

Leverage cuts both ways. The same mechanism that can turn a $10,000 deposit into a $15,000 gain can turn it into a $15,000 loss. Because you are required to maintain minimum margin, losses can force you to deposit more money or lose your position. If the market moves sharply against you overnight, you might wake up to find your position closed and your account depleted.

Futures are also more volatile than the underlying asset itself. A 2 percent move in the price of oil is a small move, but on a leveraged oil futures contract, it can wipe out your entire margin deposit. Liquidity can also dry up — during market stress, some futures contracts become hard to sell quickly, trapping you in a losing position.

Finally, futures contracts expire. You cannot hold them forever. If you want to stay in the trade, you must close the old contract and open a new one in the next expiration month, and that rolling process costs money in the form of bid-ask spreads and commissions.

Futures versus owning the asset outright

If you believe oil prices will rise, you could buy oil futures or you could buy shares in an oil company or an oil-focused exchange-traded fund (ETF). The futures route uses leverage and requires daily monitoring and margin deposits. The stock or ETF route requires you to pay the full purchase price upfront, but your loss is capped at what you invested — you cannot lose more than 100 percent.

Futures are also more transparent in terms of pricing. The futures price reflects what the market thinks the commodity will cost on the expiration date, and that price is public and updated constantly. Owning a stock or ETF means you own a piece of a company, which is a different kind of investment with different risks and rewards.

For hedging, futures are often the only practical tool. A farmer cannot buy wheat stock to hedge the price of wheat he will grow; he needs a wheat futures contract. For speculation, both routes exist, and the choice depends on how much leverage you want and how much time you can spend monitoring your position.

Frequently Asked Questions

Can I lose more money than I deposit in a futures contract?

Yes. If the market moves sharply against you, your losses can exceed your initial margin deposit. Your broker will demand additional funds to cover the loss, and if you cannot pay, the position will be closed. In extreme cases, you could owe money after the position is closed.

What happens if I hold a futures contract until expiration?

For physical commodities, you may be required to take delivery of the actual commodity — 1,000 barrels of oil, for example. For financial futures, cash settlement occurs instead. Most traders close their position before expiration to avoid delivery or the complications of final settlement.

How much money do I need to start trading futures?

Margin requirements vary by contract and exchange, but typically range from 5 to 15 percent of the contract value. A $100,000 contract might require $5,000 to $15,000 in margin. You should also have additional cash available to cover daily losses and maintain your account above the maintenance margin level.

Are futures the same as options?

No. A futures contract is a binding obligation to buy or sell at a set price on a set date. An option gives you the right, but not the obligation, to buy or sell. Options have an upfront cost (the premium) but your loss is capped at that premium. Futures have lower upfront costs but unlimited loss potential.

Why do futures prices differ from the current spot price?

Futures prices reflect what the market expects the commodity to cost in the future, plus the cost of carrying it (storage, insurance, interest) until expiration. As the expiration date approaches, the futures price converges toward the current spot price. This difference is called the basis.