Futures contract

A futures contract is a standardized agreement, traded on an exchange, to buy or sell an underlying asset at a specified price on a future date. The contract specifies the quantity, quality, delivery date, and delivery location, making it fungible and easily tradable. Unlike forward contracts, which are bilateral and customized, futures are cleared through a central clearinghouse that acts as the counterparty to both sides, reducing default risk.¹

Each exchange sets contract specifications, such as the Chicago Mercantile Exchange (CME) for commodities and financial futures. The price is determined by supply and demand on the trading floor or electronic platform. Futures positions are marked to market daily, with gains and losses credited or debited to the trader's margin account. This daily settlement ensures that losses are covered promptly, preventing the accumulation of large unpaid debts.²

The modern futures contract originated in the mid-19th century at the Chicago Board of Trade (CBOT), founded in 1848. Initially, it facilitated forward contracts for agricultural commodities like corn and wheat, allowing farmers and merchants to lock in prices and manage the risk of price fluctuations. The first standardized futures contract was introduced in 1865 for corn, and the CBOT later developed the clearinghouse system to guarantee trades.³

In the 1970s, financial futures emerged, starting with currency futures on the International Monetary Market (IMM) in 1972, followed by interest rate futures and stock index futures. These innovations expanded futures beyond physical commodities to include financial assets, making them a cornerstone of global risk management. Today, futures are traded on exchanges worldwide, including the CME Group, ICE, and Eurex, with electronic trading dominating since the late 1990s.⁴

Futures contracts serve two primary purposes: hedging and speculation. Hedgers, such as farmers, airlines, and manufacturers, use futures to lock in prices for raw materials or outputs, protecting against adverse price movements. For example, an airline may buy oil futures to secure fuel costs, while a wheat farmer sells futures to guarantee a sale price before harvest.

Speculators, including individual traders and hedge funds, take on price risk in hopes of profiting from price changes. They provide liquidity to the market, making it easier for hedgers to enter and exit positions. Additionally, arbitrageurs exploit price discrepancies between futures and spot markets, ensuring price convergence. The participation of diverse players contributes to price discovery, as futures prices reflect collective expectations about future supply and demand.⁵

While most futures are settled in cash or by physical delivery, a significant minority are never delivered; instead, positions are closed by taking an offsetting trade. In fact, less than 2% of futures contracts result in physical delivery, as most traders close out before expiration.⁶

Another niche area is the use of futures in weather risk management. The Chicago Mercantile Exchange offers weather futures based on temperature indexes, allowing energy companies to hedge against unseasonably warm or cold weather affecting demand. Similarly, futures on volatility indexes, such as the VIX, allow investors to hedge against market turbulence. These instruments highlight the adaptability of futures to non-traditional underlying assets, from electricity to freight rates, and even cryptocurrency futures, which have gained popularity since 2017.⁷

Marking to market

The daily settlement of gains and losses on a futures position based on the closing price.

Clearinghouse

An intermediary that guarantees the performance of futures contracts, reducing counterparty risk.

Hedging

Using futures to offset the risk of adverse price movements in an underlying asset.

Speculation

Trading futures to profit from price changes, without an underlying commercial interest.

Offset

Closing a futures position by taking an equal and opposite position, avoiding delivery.