What is a futures contract?
A futures contract is an agreement to buy or sell an asset at some point in the future. These contracts will specify the price the asset will be exchanged for, the exact time of expiry, and the quantity of goods.
Futures contracts can be used to speculate on commodities, currencies and indices. They’re often used to hedge against adverse price movements, as they effectively enable the user to lock in a future price at which to execute their position.
Futures contracts are traded on exchanges, meaning they’re subject to a lot more regulations than over-the-counter contracts such as CFDs or forwards. This can be beneficial for businesses, as they guarantee a level of quality regardless of where the asset is from. For example, Crude Oil futures ensure that regardless of the refinery, a buyer can be sure they’ll be getting the same standard of oil.
Futures contracts are referred to by their delivery month. So, a WTI contract with an expiry in December would be the ‘December WTI’. Depending on the type of asset, delivery can be anywhere from a month to a few years – all of this information would be found in the exchange’s contract specifications. Normally, you can trade on a futures contract until a few days before the specific expiry date.
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What is a futures contract size?
A futures contract size is the amount of the underlying asset that will be exchanged. These sizes are standardised by exchanges and will vary depending on whether it’s a physical commodity, like oil, or a financial product, like a currency.
Futures contracts come in two sizes: standard and minis. For example:
WTI Crude Oil
$250 x the value of the S&P
$50 x the value of the S&P
What does it mean to take delivery of a futures contract?
Taking delivery of a futures contract refers to physical settlement, in which the buyer receives the asset from the seller. If they’d taken out a futures contract on crude oil, they’d receive 1,000 barrels of oil. This comes with difficulties like storage needs and insurance costs for precious materials.
The alternative to delivery is cash settlement. This is where the buyer and seller just exchange the monetary value of the asset, rather than the asset itself. Speculative positions will always be settled in cash.
Types of futures contracts
There are a number of types of futures contracts, the most common instruments that futures are traded on are forex, indices and commodities – mainly oil.
Forex futures, or currency futures, specify the price you can buy one currency for using another on a future date. They’re exchange-traded, which makes it less flexible than normal FX trading – which is over the counter – and a much smaller market. However, futures contracts can provide an entryway into forex for those who are used to trading more regulated products, like shares.
It’s important to look at the liquidity of a currency future before you trade, as the major pairs will offer significantly more daily volume than smaller pairs.
Forex futures are normally used for hedging and speculative purposes, rather than physically settling the contract.
Index futures are used to buy or sell a stock market index at a set price to be settled at a date of expiry. As a stock index is nothing more than a group of shares – for example the Dow Jones represents 30 of the largest shares on the US stock market – there is no physical asset underpinning the market. So, most trading takes place via futures and other derivatives such as CFDs.
Index futures are most commonly used for hedging, or to speculate on market movements. As there are no physical asset to trade, index futures are always settled in cash.
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Oil futures enable market participants to establish a price for oil at a coming date. No one can know for sure what the market’s price will be in the future, but they can choose a level which they’re confident it will pass through.
Unlike other types of commodity futures, oil contracts settle every month – others may only have expiry dates a few times a year. This is because oil markets are particularly volatile, so the regular expiries make it easier for market participants to speculate on the price of oil.
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Futures contract example
For example, Crude Oil is currently selling at $60 a barrel, and a futures contract for $65 per barrel is available for three months’ time. As you believe the price of WTI will rise beyond $65 by the time of expiry, you buy the contract.
The market actually rises to $75. That means your prediction is correct and you could buy Crude at $65 per barrel and sell it on for $10 profit.
However, if your prediction was incorrect, and the market ended up short of $65, your contract could result in you paying above the market price in order to settle your contract.
Forward contract vs futures contract
A forward contract is essentially a futures contract that is traded over the counter, rather than on an exchange. So, while futures are standardised and prices are settled on set dates throughout the year, a forwards are fully customisable between the two parties and settled whenever they choose to.
Options contract vs futures contract
An options contract gives the holder the right – but not the obligation – to buy or sell an asset at a specific price at a specific time. Both contracts enable people to speculate on the future market price of an asset, but while futures always result in the physical or cash-equivalent settlement of the contract, an option can be left to expire worthless.