HOW FUTURES CONTRACTS WORK: BASICS AND KEY FEATURES

A futures contract is a standardised legal agreement to buy or sell an asset at a predetermined price on a specific date in the future. These contracts are traded on an organised exchange and are primarily used for hedging risk or speculating on price movements. Investors, traders, and institutions use futures contracts to lock in prices or attempt to profit from market fluctuations.

Futures contracts encompass a wide range of underlying assets, including commodities (such as crude oil, gold, and wheat), financial instruments (like indices, currencies, and interest rates), and even cryptocurrencies. Each contract outlines fixed specifications concerning the quality, quantity, and delivery terms of the asset, reducing ambiguity and making trading seamless and efficient.

Unlike forward contracts, which are bespoke agreements between two parties, futures are standardised and cleared through centralised exchanges such as the Chicago Mercantile Exchange (CME) or Intercontinental Exchange (ICE). The use of clearing houses helps mitigate counterparty risk, making futures contracts an attractive and trusted instrument in financial markets across the globe.

These contracts play a pivotal role in market price discovery and risk management. For example, a farmer might use a futures contract to lock in the selling price of wheat before the harvest to secure income against price volatility. Similarly, airlines might use futures to manage the cost of jet fuel, while traders might speculate on interest rate trends or foreign exchange fluctuations.

To participate in futures markets, traders typically need to open an account with a brokerage that supports derivatives trading. The broker acts as an intermediary, facilitating trade execution, managing margin requirements and ensuring regulatory compliance. Every futures market is subject to regulatory oversight—such as from the Commodity Futures Trading Commission (CFTC) in the U.S.—which ensures fair practices and transparency for all participants.

Understanding how these contracts work—including their structure, margin obligations, and expiration mechanics—is essential for anyone engaging in futures trading. In the following sections, we will explore these aspects in detail.

Standardisation is a defining characteristic of futures contracts, setting them apart from other forms of derivative agreements. It refers to the uniform specification of each futures contract, including the asset type, contract size, delivery date, pricing units, and exchange mechanism. These standard terms are established by the exchange on which the contract is traded, thereby ensuring consistency and facilitating a highly liquid market environment.

Several key components are standardised within a futures contract:

• Underlying Asset: This may be a physical commodity (corn, natural gas, precious metals) or a financial instrument (interest rate, index value, currency).
• Contract Size: Defines the quantity of the asset represented by one contract—for example, 100 barrels of crude oil or 5,000 bushels of corn.
• Delivery Month: Specifies the month in which the contract expires and settlement occurs. Each underlying asset usually has multiple delivery months available throughout the year.
• Pricing Unit: States how prices are quoted; for example, in U.S. dollars per barrel or cents per bushel.
• Tick Size: The minimum price movement that can occur in trading, impacting both price increments and valuation of profits and losses.
• Settlement Procedure: Clarifies whether the contract settles by physical delivery of the asset or by cash settlement.

Thanks to standardisation, futures contracts can be easily traded on electronic exchanges and cleared via central counterparty systems. This universality attracts a wide pool of participants and enhances market depth and transparency. It also eliminates uncertainty over contract terms, allowing traders to focus solely on market dynamics rather than negotiating bespoke details.

Additionally, the presence of standard features enables sophisticated risk management, benchmarking, and arbitrage strategies. For instance, portfolio managers may hedge against interest rate risks using standardised bond futures, while commodity traders might use oil futures to balance physical inventory risks.

Exchanges periodically review and adapt standard contract features to reflect changing market practices or emerging asset types. For example, the increased popularity of cryptocurrencies has led to the launch of standardised Bitcoin and Ethereum futures on regulated exchanges. As these instruments evolve, standardisation remains crucial to ensuring trust, clarity and efficiency in futures trading across industries and geographies.

Overall, standardisation grants futures contracts the transparency and scale required for active global participation. Whether for hedging or speculative purposes, the uniform nature of futures remains integral to their function and reliability.

Margin in futures trading refers to the amount of capital a trader must deposit with a clearinghouse or broker to initiate and maintain a position. Unlike stocks, where you pay the full market value (or borrow funds with a margin account), futures require only a fraction of the contract's value as collateral—this is referred to as the “initial margin.”

The purpose of margin in futures trading is twofold: to ensure both parties in a contract meet their financial obligations and to reduce systemic risk across the market. Margin levels are set by exchanges and clearing houses based on the volatility of the underlying asset, historical price fluctuations and current market dynamics.

There are typically three categories of margin in a futures contract:

• Initial Margin: The upfront deposit required to open a position. It acts as a performance bond and is usually a small percentage (e.g. 5–15%) of the full contract value.
• Maintenance Margin: The minimum balance that must be maintained in the margin account. If the account falls below this level due to adverse price movement, the trader receives a “margin call.”
• Variation Margin: This refers to the daily mark-to-market adjustment. Profits and losses are calculated each trading day and settled accordingly, ensuring margin accounts reflect current market value.

Consider an example: an investor opens a crude oil futures position with a contract valued at £50,000. The initial margin might be set at £5,000. If the contract's value declines and the account falls below the maintenance level (say, £4,000), a margin call will be issued, requiring the investor to replenish funds to continue holding the position.

This practice of marking to market ensures that unrealised losses are addressed promptly, reducing the risk of default. It's important to note that both long and short positions are subject to the same margin processes, ensuring fairness in the marketplace.

Margin requirements enhance market stability by controlling leverage. However, they also introduce potential for significant capital loss, as traders could be required to post additional funds rapidly in volatile markets. For speculative traders, this makes risk management techniques—like stop-loss orders and portfolio diversification—especially vital.

Brokers may set margin requirements higher than exchange minimums, especially during periods of high volatility or when dealing with inexperienced clients. Traders should thoroughly understand margin implications before entering futures positions, as failure to meet a margin call could result in the forced liquidation of holdings or legal action.

In summary, margin is not a down payment but a financial safeguard. It provides assurance that each party has skin in the game, helping to uphold the integrity and resilience of futures markets globally.