Overview

A future is a financial agreement between a buyer and a seller. Entering into a futures contract obligates the buyer and the seller to buy and sell an underlying asset at a certain date in the future, at a specified price. Both parties to the contract must fulfill the terms on the settlement date. There is no option to let the contract expire without buying or selling.

A futures contract is a standardized contract. The future date is called the delivery date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date.

If an investor believes the underlying asset will rise, they can buy futures on that asset - called a long futures position. If an investor believes the underlying asset price will fall, you can sell futures - called a short futures position.

Either buying or selling a future opens a futures position. Doing exactly the opposite, selling or buying the same future, closes a position. Usually, most futures contracts are closed before they expire.

When a futures contract is closed, the seller delivers the commodity to the buyer, or, if it is a cash-settled future, the cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

It is impossible to accurately to know if an asset's price will go up or down. Therefore, like most investments, futures carry a risk that prices may go in a direction opposite than anticipated.

Although options and futures are closely related, they are different. Each has advantages and disadvantages and can be used separately or in combination to achieve a variety of different risk management and investment objectives.

Futures traders are traditionally placed in one of two groups: those hedging, who have an interest in the underlying commodity and are seeking to reduce the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity solely to make a profit. Hedgers typically include producers and consumers of a commodity.

Using futures, an investor can profit in a falling market as well as a rising market. Normally, when investing in company stocks, investors buy low and sell high in order to profit. With futures, an investor can buy low and sell high, called going long. There is also the opportunity to sell futures, called going short. If an investor believes that an asset's value will fall, he'll consider selling futures. If the view changes and the asset's value falls in line with the underlying share price, the position can be closed by buying back the future for less in order to make a gain.

Futures are traded on established exchanges, similar to stock exchanges. The exchange's clearinghouse acts as counterparty on all contracts. Futures can be based on any number of different underlying assets. In addition to futures based on individual company shares and stock market indices, there are also futures based on bonds, interest rates, and commodities such as oil, corn, and metals. The Commodity Futures Trading Commission (CFTC), a government agency, regulates and oversees all futures trading in the United States. The commission can implement fines and other punishments. Each exchange also has its own rules and under can fine members accordingly, on top of regulation by the CFTC.

To minimize credit risk to the exchange, traders must post a margin, typically 5%-15% of the contract's value, which acts as insurance that the trade will be executed. Both buyer and seller pay the initial margin. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading. A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.