Futures

Overview

A futures contract is a standardised, exchange-traded agreement which obligates a buyer to purchase an asset and a seller to sell one at a specified price on a specific future date. 

Examples

The most common examples include commodity futures, which make up the majority of firms' costs, such as oil and farming crops. Stock index futures such as S&P 500 futures are also vastly used to gain or hedge equity market exposure, with currency futures also being very popular to protect firms' costs.

Mechanics

Futures work by requiring both parties to post margin, which is collateral held to cover potential losses that could occur. Positions are then marked to market daily, meaning gains and losses are settled each day rather than only at the end of the contract on the expiry date. 

Unlike a forward contract, which is a private, customisable agreement between two parties, a futures contract is standardised in size and terms and traded on an exchange, which makes it far more liquid than forwards. 

Uses

It is usually used for hedging, with classic examples including farmers selling wheat futures to lock in a price for their crop months before harvest, protecting against the risk of prices falling when it’s ready to sell, whilst the same contract can equally be used purely speculatively by a trader with no interest in taking physical delivery of the wheat. Another classic example is airlines using futures to lock in prices of jet fuel in the future, allowing them to plan their future endeavours way more accurately. 

Risks

Futures can be highly leveraged, which means losses can exceed the trader's initial margin deposit, with a rapidly moving market triggering market calls and requiring more funds for a position to be kept open, which can be catastrophic if the contract is being used for speculative purposes. Entire cash pots can be wiped out keeping the position open, which may not even pay off in the long-term.