What a futures contract actually is

A futures contract is an agreement to buy or sell a specific thing — wheat, oil, gold, a stock index, a currency — at a set price on a set date in the future. You do not own the thing yet. You are locking in a price now for a transaction that will happen later, usually three to twelve months away.

The contract itself is what you trade, not the underlying thing. When you buy a futures contract for crude oil, you are not taking delivery of barrels. You are holding a contract that says "I agreed to pay $75 per barrel for 1,000 barrels on December 15." That contract can be sold to someone else before December 15 arrives. Most futures traders close out their position before the delivery date ever comes.

Futures trade on organized exchanges — the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) are the largest in the United States. Each contract has a standardized size, expiration date, and price movement rules set by the exchange. That standardization is what makes futures liquid: thousands of contracts trade every day, and you can usually enter or exit a position quickly.

Key Takeaways

  • A futures contract locks in a price now for something you will buy or sell on a specific future date, but most traders close the position before delivery.
  • Futures use leverage, meaning you control a large contract value with a small upfront deposit called margin, which amplifies both gains and losses.
  • Futures contracts are standardized by the exchange and trade in high volume, making them liquid but also exposing you to rapid price swings.
  • Futures are used both by people hedging real business risk (a farmer protecting against crop price drops) and by speculators betting on price direction.
  • Your broker holds your margin deposit and can force you to close a position if losses eat into it, a process called a margin call.

How leverage works in futures trading

Futures use leverage, which means you control a contract worth far more than the money you put down. That upfront money is called margin. If you want to trade one crude oil contract (1,000 barrels), your broker might require $5,000 in margin. The contract itself might be worth $75,000 at current prices, but you only deposit $5,000 to control it.

Leverage cuts both ways. If the price of oil rises $1 per barrel, your contract gains $1,000 — a 20 percent return on your $5,000 margin. If the price falls $1 per barrel, you lose $1,000, a 20 percent loss. A $5 move in either direction wipes out your entire margin deposit. A $6 move puts you in a deficit, and your broker will issue a margin call — a demand for more money to cover the loss. If you do not deposit it, the broker closes your position automatically.

This is why futures are riskier than buying the underlying thing outright. You can lose more than you put in. A farmer buying futures to lock in a crop price is using leverage to manage a real business risk. A trader betting on price direction is using leverage to amplify a bet. The mechanics are identical; the intent is different.

Who uses futures and why

Futures serve two main purposes: hedging and speculation. A hedge is a position taken to offset risk in something else you own or plan to own. An airline buys jet fuel futures to lock in fuel costs for next year, protecting itself against a price spike. A wheat farmer sells wheat futures at harvest time to lock in a price, protecting against a price drop before the crop sells.

A speculator takes a futures position to profit from a price move, not to hedge an underlying business. A trader might buy gold futures because they believe the price will rise, or sell stock index futures because they believe the market will fall. Speculators provide liquidity — they are the counterparty to hedgers, willing to take the risk that hedgers want to shed.

Large institutions, commodity producers, and financial firms dominate futures trading by volume. Individual traders and investors can open a futures account with a broker, but the leverage and speed of the market mean losses can accumulate quickly. Most individual traders lose money over time.

How prices move and how you make or lose money

Futures prices move based on supply and demand, just like any other market. A weather event that threatens a crop sends grain prices up. A report that oil inventories are rising sends crude prices down. Economic data, geopolitical events, and shifts in expectations all move prices minute by minute during trading hours.

Your profit or loss is the difference between the price you entered at and the price you exit at, multiplied by the contract size. If you buy one gold futures contract at $1,950 per ounce and sell it at $1,960, you make $10 per ounce. One gold contract is 100 ounces, so your profit is $1,000. If you had sold at $1,940 instead, your loss would be $1,000. The exchange settles your account daily, crediting gains and debiting losses to your margin account.

Futures prices can move sharply in a single day, especially for contracts with thin trading volume or during news events. A 5 percent move in a day is not unusual for some commodities. With leverage, a 5 percent move in the contract value can mean a 50 percent or larger move in your margin account. This speed and volatility is what makes futures attractive to traders seeking large moves and dangerous to traders who underestimate risk.

The difference between futures and options

Futures and options are both derivatives — contracts whose value comes from an underlying asset — but they work differently. A futures contract obligates you to buy or sell at the set price. An option gives you the right, but not the obligation, to buy or sell. With a futures contract, you must follow through or close the position. With an option, you can let it expire worthless and walk away, losing only the premium you paid upfront.

Options have a defined maximum loss: the premium you paid. Futures have no defined maximum loss; you can lose more than your margin deposit if the market moves far enough against you. Options are generally considered less risky for this reason, though they are also more complex to price and trade. Most individual investors who want leveraged exposure to price moves start with options rather than futures.

What happens at the expiration date

Every futures contract has an expiration date. For agricultural commodities, expiration usually aligns with the harvest or delivery season. For financial futures like stock indices or currencies, expiration dates are set by the exchange, typically the third Friday of the month. As expiration approaches, the futures price converges toward the spot price — the price of the actual thing trading right now.

If you hold a contract to expiration, you must either take delivery of the underlying thing or cash-settle the contract, depending on the contract type. Most financial futures and many commodity futures are cash-settled: the exchange pays the difference between your entry price and the final settlement price. Agricultural futures may require physical delivery, which is why most traders close positions weeks before expiration.

Traders typically roll a position forward by closing the near-term contract and opening a new one with a later expiration date. This keeps the position open without taking delivery. The cost of rolling depends on the difference between the two contract prices, which reflects market expectations about future supply and demand.

Common mistakes and risks to understand

The most common mistake is underestimating leverage. A trader sees a $5,000 margin requirement and thinks the maximum loss is $5,000. It is not. A $10 move in the contract price wipes out the margin and creates a deficit. The broker will force a sale to stop the bleeding, but if the market is moving fast, the sale may happen at a worse price than expected, turning a $10,000 loss into a $12,000 loss.

Another mistake is trading illiquid contracts. Some futures have thin trading volume, meaning wide bid-ask spreads and difficulty exiting a position quickly. If you are trapped in a losing position in a thin contract and the market moves against you, you may have to accept a much worse price to get out. Always check the volume and open interest of a contract before trading it.

Overconfidence in price prediction is a third trap. Futures make it straightforward to act on a hunch because leverage lets you control a large position with small capital. But predicting short-term price moves is extremely difficult. Most individual traders who trade frequently lose money. The odds are against you, and the leverage works against you when you are wrong.

Frequently Asked Questions

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

Yes. If the market moves sharply against your position, losses can exceed your margin deposit. Your broker will issue a margin call demanding more money, and if you do not deposit it, the broker will close your position. If the market is moving fast and liquidity is thin, the forced sale may happen at a price worse than the margin call level, creating a deficit you owe the broker.

Do I have to take physical delivery of the commodity?

Most individual traders close their positions before expiration and never take delivery. Financial futures like stock indices are cash-settled automatically. Agricultural futures may require delivery if you hold to expiration, which is why traders typically close or roll positions weeks before the delivery date arrives.

What is the minimum amount of money I need to start trading futures?

Margin requirements vary by contract and broker, but typically range from $1,000 to $10,000 per contract. However, having the minimum margin is not the same as having enough money to trade safely. Most professionals recommend keeping several times the margin requirement in your account to absorb losses without triggering a margin call.

How is futures trading taxed?

Futures profits and losses are taxed under Section 1256 rules, which treat most futures contracts as 60 percent long-term capital gains and 40 percent short-term capital gains, regardless of how long you held the position. This can be more favorable than short-term capital gains rates, but you should consult a tax professional about your specific situation.

What is the difference between a futures contract and a forward contract?

Both lock in a price for a future transaction, but futures trade on organized exchanges with standardized terms and daily settlement, while forwards are custom contracts negotiated between two parties. Futures are liquid and regulated; forwards are illiquid and carry counterparty risk. Most individual traders use futures, not forwards.