Quick Explainer, Futures Contracts

Investors buy and sell stocks and bonds every day. Usually, they are purchased as an immediate transaction on an exchange. An agreement to buy or sell something later, at a price set now, is called a futures contract.

Our definition of a futures contract is:

Futures Contract: A futures contract is a legal obligation to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future.

Every futures contract has two sides, a buyer and a seller. The buyer is long, meaning they profit if the price of the underlying asset rises. The seller is short, meaning they profit if the price of the underlying asset falls. 

This contrasts with stocks. Stock investors profit only if the price rises. Futures investors can potentially profit from either direction of movement depending on which side of the trade they take. 

This ability to be on either side of the trade is why futures contracts are the building blocks of strategies that intend to perform in both rising and falling markets. 

Futures contracts only require investors to put up collateral, called margin*, to enter a contract. This enables investors to use a mechanism called leverage*. Because the total contract value (or notional value*)is higher than the margin, it enables investors to gain higher total notional value versus what they would be able to purchase directly on the underlying assets. 

As an example, a crude oil futures contract represents 1,000 barrels of oil. If crude oil is trading at $100 a barrel, the contract would have a notional value of $100,000. To enter into this contract, an investor might have to post 10% or $10,000 of collateral. They now have exposure to $100,000 of crude oil contracts. 

If the price of oil increases 10% to $110 a barrel, the notional value of those contracts increases to $110,000. Because the investor only posted $10,000 of collateral, this represents a 100% gain. This amplification is due to leverage. Conversely, if the price dropped 10% to $90 a barrel, the investor could lose all of the collateral they posted. The broker can demand the investor post more collateral (known as a margin call*). If the investor doesn’t meet that demand, the position can be closed out and any losses come out of the already posted collateral. 

Futures are an efficient tool for getting market exposure with smaller amounts of capital, but the leverage that makes them efficient also makes them risky.

The biggest risk of futures contracts is the asymmetric profile on the upside and downside loss potentials. The long side of the contract has a bounded loss because the price of the underlying asset has a floor at zero. With leverage, that loss can still exceed the collateral the investor posted.

On the short side, though, the losses are theoretically limitless. Because there is no upper limit on how high a price can go, the losses on a short futures position grow as the price moves against it.

This combination of leverage and asymmetric risk is why futures are typically used inside professionally managed strategies that have risk controls built in.

Futures markets are built to give efficient access to markets that are harder for investors to reach via stocks and bonds. These markets include commodities, currencies, and interest rates. This market access along with the ability to utilize leverage enables strategies that are intended to perform across market conditions.

These markets have deep liquidity, and the contracts are standardized and exchange traded. 

Futures contracts have expiration dates. They are not perpetual like a stock. Most futures are settled in cash at the expiration date. Physical delivery is rare in financial markets. 

Futures are complex instruments that require a foundational understanding of the underlying assets. They enable a wide range of potential investment strategies beyond the typical equity and fixed income portfolio but come with risks that must be managed effectively.