What Are Futures? How Futures Trading Works

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A futures contract is a standardized agreement, traded on an exchange, to buy or sell a set quantity of an underlying asset at a price agreed today, with settlement on a specified future date. Both parties are bound. The buyer (the “long”) must take the asset or its cash equivalent at the contract price, and the seller (the “short”) must deliver it, whatever the market price is when the contract expires. Futures are derivatives: their value comes from the price of something else, such as a stock index, crude oil, wheat, a currency or a Treasury bond.

Futures trading means buying and selling these contracts, usually to profit from price changes or to protect against them. Most traders close their positions before expiration instead of exchanging the underlying asset.

What Are Futures?

A futures contract fixes three things in advance: what is being traded, how much of it, and at what price and date the trade settles. The underlying asset can be a commodity, a financial instrument or an index. Stock futures (also called stock market futures or equity futures) are based on individual company shares or on indexes such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq indexes. Exchanges such as the Chicago Mercantile Exchange also list contracts on agricultural products, metals, energy, interest rates, currencies, cryptocurrencies and even weather.

The agreed price is the futures price. It is not a forecast in any formal sense. It is the price at which buyers and sellers are willing to commit today for settlement later, and it changes continuously as the market trades.

How Futures Trading Works

Standardized contracts

Each exchange-listed contract has a fixed specification: the quantity of the underlying (a set number of barrels, bushels or ounces, or a dollar multiplier on an index), the quality or grade, the expiration months, the minimum price increment and the settlement method. Because every contract of a given type is identical, any buyer can trade with any seller, which supports price transparency and liquidity.

The clearinghouse and margin

When a trade is matched, the exchange’s clearinghouse steps in as the counterparty to both sides. The buyer’s contract is effectively with the clearinghouse, and so is the seller’s. This removes the need to trust the original counterparty.

To support that guarantee, both the buyer and the seller post margin. In futures, margin is a performance bond, not a loan or a down payment on the asset:

• Initial margin is the deposit required to open a position. The amount depends on the contract and the exchange’s requirements, and brokers can set their own higher levels based on contract size, the client’s creditworthiness and their own terms.
• Maintenance margin is the minimum account equity required to keep the position open. If losses push equity below this level, the broker issues a margin call, and the trader must add funds, typically enough to restore the initial margin level, or the position can be closed.

Daily mark-to-market

Futures accounts are settled daily. At the end of each session, the exchange sets a settlement price, and every open position is revalued against it. If the price moved in your favor, cash is credited to your account. If it moved against you, cash is debited. Gains and losses are realized in cash each day rather than waiting for expiration, which is why a futures position’s account value can swing sharply from one session to the next.

Contract months and rolling

Futures expire on set dates and are listed by month. Stock index futures on the S&P 500, for example, follow a quarterly cycle of March, June, September and December. The contract with the nearest expiration is the front-month contract, and it often carries the most trading activity. A trader who wants to keep exposure beyond expiration “rolls” the position: closing the expiring contract and opening the same position in a later month. Short-term traders tend to work in the front month, while hedgers with longer horizons may use deferred months.

Settlement: cash or physical delivery

How a contract settles depends on the underlying:

• Physical delivery applies to many commodity contracts, such as crude oil, gold or wheat. A long who holds through the delivery period receives the actual commodity, and a short must deliver it.
• Cash settlement applies to stock index futures and many financial contracts. No shares change hands. At expiration, the difference between the contract price and the final settlement value is paid in cash.

Delivery obligations arise only at expiration, not before. Traders who do not want delivery close or roll their positions ahead of time.

Worked Example: How Leverage Affects a Futures Position

Assumptions: a stock index future with a multiplier of $50 per index point, a futures price of 5,000, and an initial margin of 10% of contract value. The maintenance margin is assumed at $20,000. Commissions and fees are ignored.

1. Contract value (notional): 5,000 × $50 = $250,000.
2. Initial margin: 10% × $250,000 = $25,000. The trader controls $250,000 of exposure with $25,000.
3. If the index rises 2% to 5,100: gain = 100 points × $50 = $5,000, or 20% on the $25,000 margin.
4. If the index falls 120 points to 4,880: loss = 120 × $50 = $6,000. Account equity drops to $19,000, below the $20,000 maintenance level, triggering a margin call to restore the account to $25,000.
5. If the index falls 10% to 4,500: loss = 500 × $50 = $25,000, which equals 100% of the initial margin. A larger fall would produce a loss greater than the amount deposited.

Every 1% move in the index produces roughly a 10% change in the trader’s margin, in both directions, and losses are collected in cash daily. Traders size positions from the notional value and a defined loss limit, not from the margin requirement alone; a position size calculator applies that logic.

Using Futures to Speculate

A speculator takes a view on price direction without any need for the underlying asset.

• Going long: a trader who expects prices to rise buys a contract. If the futures price rises, the position gains and can be sold before expiration to lock in the profit. If it falls, the position loses.
• Going short: a trader who expects prices to fall sells a contract. If the price declines, the trader buys back the contract at the lower price and keeps the difference. If the price rises instead, the short loses.

Speculators also matter to the market’s structure. They take the other side of trades from hedgers, which helps producers and investors find counterparties when they want to transfer price risk.

Using Futures to Hedge

Hedging uses futures to offset price risk in a position or business the hedger already has. The goal is protection, not profit.

Portfolio hedge (hypothetical)

A fund manager runs a $100 million portfolio that tracks the S&P 500 and is concerned about a short-term decline. Assume the index future trades at 5,000 with a multiplier of $250 per point, and that the portfolio moves one-for-one with the index.

• Value covered by one contract: 5,000 × $250 = $1,250,000
• Contracts needed: $100,000,000 ÷ $1,250,000 = 80
• The manager sells 80 contracts.

If the index falls 10% to 4,500 over the following months, the portfolio loses about $10 million. The short futures gain 500 points × $250 × 80 = $10 million, offsetting the loss. If the index rises instead, the portfolio gains and the futures lose a similar amount. The manager gives up the upside in exchange for removing the downside.

In practice, the offset is rarely exact. A portfolio that does not track the index perfectly, a hedge sized in whole contracts, and differences between the futures price and the spot index (known as basis) all leave some residual risk.

Producer hedge (hypothetical)

A grain farmer expects to harvest 20,000 bushels in several months. Assume a wheat contract covers 5,000 bushels and the futures price for the harvest month is $6.00 per bushel. The farmer sells 4 contracts.

If wheat falls to $5.00 by harvest, the farmer receives $1.00 less per bushel on the physical crop, about $20,000 less in total. The short futures gain $1.00 × 20,000 bushels = $20,000. The two roughly cancel, and the farmer’s effective price stays near $6.00. A food processor that needs to buy wheat could do the opposite, buying futures to lock in a purchase price.

Advantages and Limitations

Advantages

• Capital efficiency: margin controls large exposures with a small deposit.
• Hedging: producers, consumers and investors can lock in prices and reduce uncertainty.
• Two-way trading: going short is as simple as going long.
• Central clearing: the clearinghouse reduces counterparty risk.
• Trading hours: many major contracts trade nearly around the clock on weekdays, outside regular stock market hours.

Limitations

• Leverage cuts both ways: small adverse moves can wipe out the margin, and losses can exceed it.
• Daily cash calls: mark-to-market can force a trader to add funds or exit before a view plays out.
• Hedges remove upside: a hedger who locks in a price forgoes gains if the market moves favorably.
• Expiration and rolling: positions must be closed or rolled, and rolling has costs and price differences between months.
• Delivery risk: holding a physically settled contract into delivery creates obligations most traders are not set up to meet.

Futures vs. Related Instruments

Futures vs. options. An option gives the buyer the right, but not the obligation, to buy or sell at a set price. American-style options can be exercised any time before expiration. The option buyer pays a premium and can lose no more than that premium. A futures position carries an obligation on both sides, no premium, and losses that can exceed margin. Futures pay more when a forecast is right and cost more when it is wrong; buying options caps the loss at the premium.

Futures vs. forwards. A forward contract is also an agreement to transact at a set future price, but it is negotiated privately between two parties, customized, and usually settled only at maturity. Futures are standardized, exchange-traded, centrally cleared and marked to market daily. A forward carries direct exposure to the other party’s ability to pay; a future does not, in the same way.

Futures vs. stocks. Buying a stock gives ownership in a company with no expiration date. A stock future gives price exposure for a set period, with leverage, without ownership, dividends or voting rights.

Futures vs. perpetual futures. Perpetual futures, common in crypto markets, have no expiration date. Instead of converging at expiry, they use periodic funding payments between longs and shorts to keep their price near the underlying asset.

Regulation of Futures

In the United States, futures markets are overseen by the Commodity Futures Trading Commission (CFTC), created by Congress in 1974. Its mandate includes protecting the integrity of futures prices, preventing fraud and abusive trading practices, and regulating the brokerage firms that handle futures accounts. Exchanges and clearinghouses add their own rules, including margin requirements and position limits.

FAQs

The Bottom Line

Futures matter to speculators betting on price direction and to producers, consumers and fund managers who need to lock in prices. Leverage magnifies results in both directions, and losses can exceed the margin deposited, so traders should size positions from notional value and a defined loss limit. Hedgers gain protection from adverse moves but give up upside and still face some residual risk from basis and imperfect matching.