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How do Futures contracts work?​

​​​​A Futures contract is a legally binding agreement to buy or sell an asset at a predetermined price on a specified Future date. These contracts are traded on regulated exchanges and help investors speculate, hedge risk, or arbitrage price differences.

Key Components of a Futures Contract

​Each futures contract has standardized features set by the exchange:
  1. Underlying Asset – The commodity, index, or financial instrument being traded (e.g., crude oil, S&P 500, gold).
  2. Contract Size – Specifies the quantity of the asset (e.g., 1 crude oil contract = 1,000 barrels).
  3. Expiration Date – The date when the contract expires and must be settled.
  4. Price – The agreed-upon price at which the asset will be bought or sold.
  5. Margin Requirement – A small deposit (initial margin) required to open a position.
  6. Tick Size & Value – The minimum price movement and its monetary value (e.g., in S&P 500 futures, a 1-point move = $50).

 How a Futures Trade Works

Futures contracts are standardized and traded on exchanges like CME Group, ICE, or Eurex. Here’s how the process work:

Opening a Futures Position
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​A trader buys (long) a futures contract expecting the price to rise.
A trader sells (short) a futures contract expecting the price to fall.

Example:
  • A trader buys a gold futures contract at $1,800 per ounce for settlement in three months.
  • The contract represents 100 ounces of gold (total contract value = $180,000).
  • If gold prices rise to $1,900, the trader profits.
  • If gold falls to $1,700, the trader loses money.

Mark-to-Market & Margin Calls
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  • Futures are marked-to-market daily – Gains/losses are credited/debited at the end of each trading day.
  • If losses exceed the maintenance margin, a margin call requires more funds to keep the position open.

Closing or Rolling Over a Position
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  • Close the Position – Traders can buy or sell opposite contracts to exit before expiration.
  • Roll Over – Traders extend their position by moving to a later expiration contract.
  • Settlement – If held until expiration, contracts are cash-settled (e.g., S&P 500 futures) or physically settled (e.g., crude oil).

Example of Futures Trading

Scenario 1: Profitable Trade
  • A trader buys 1 crude oil futures contract at $80 per barrel (contract size = 1,000 barrels).
  • Oil price rises to $85.
  • Trader sells the contract at $85.
  • Profit = (85 - 80) × 1,000 = $5,000.

Scenario 2: Losing Trade
  • Same trade as above, but oil drops to $75.
  • Loss = (80 - 75) × 1,000 = $5,000.

 Settlement of Futures Contracts

Futures contracts can be settled in two ways:
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  1. Cash Settlement – No physical delivery; gains/losses are settled in cash (e.g., stock index futures).
  2. Physical Delivery – The actual asset is delivered upon expiration (e.g., commodities like crude oil, gold).
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Most traders close positions before expiration to avoid physical delivery!

 Key Takeaways

Futures contracts are agreements to buy/sell an asset at a set price in the future.
Traders can profit from price movements by going long (buy) or short (sell).
Margin and leverage allow traders to control large positions with small capital.
Mark-to-market ensures daily profit/loss adjustments.
Most futures contracts are closed or rolled over before expiration.
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