Futures contracts are agreements to buy or sell an underlying asset at a predetermined price on a set future date. Traders and investors like yourself may get into futures trading in search of diversifying their portfolios, risk management or to seek profit.
What are future contracts?
Futures contracts are agreements made publicly to buy or sell a specific underlying asset at a set future date. An underlying asset can be, for example, a security — Apple Inc. stock (AAPL) is a stock that can theoretically be bought or sold in the future. However, not all stocks have futures contracts. If you want to use stocks as futures contracts, check exchanges like the Chicago Mercantile Exchange (CME) Group to find available Single Stock Futures (SSF).
What sets futures contracts apart is that once the price is agreed upon, it remains fixed until the set date when you buy or sell the futures contract. The Commodity Futures Trading Commission (CFTC) regulates and oversees futures contracts. By setting and enforcing rules, the CFTC ensures fair, transparent and free-from-fraud futures trading.
How do future contracts work?
Future contracts are agreed-upon contracts that are delivered on the due date. This agreement means you must buy or sell in the future with one of the two goals in mind: risk aversion or profit.
Risk management plays a vital role in futures trading, as market fluctuations can lead to significant gains or losses. Stop-loss orders, a widely used tool among traders, are employed by 88% of traders to protect capital and limit downside risk. Similarly, position sizing is an essential component of portfolio protection, with 62% of traders incorporating it into their strategy.(1) By strategically managing trade sizes and setting exit points, traders can better navigate the volatility inherent in futures markets.
To calculate your risk or potential profits, we will provide you with an example, as well as a short explanation of the behavior of each of the three types of futures traders (Speculators, Producers and Position holders).
To calculate your profits or losses on a futures contract, you need to remember some key stakeholders that we will apply to this theoretical example:
Let’s say you buy 1 Gold Futures contract at $1,800 per ounce. The contract size is 100 ounces.
- Current Price: Gold futures are now at $1,810 per ounce.
- Price Movement: The price moved $10.
- Tick Size: The tick size for Gold is $0.10.
Profit Calculation:
- The number of ticks = $10 / $0.10 = 100 ticks.
- The value of one tick = $0.10 x 100 ounces = $10.
- Total Profit = 100 ticks x $10 = $1,000.
Your profit from this trade is $1,000
| Producers | Use futures to hedge against price risk, ensuring stable revenue. | Sell gold futures at $1,800 to lock in a future selling price. | Protect against falling prices, securing known revenue. |
| Speculators | Use futures to profit from price movements based on market predictions. | Buy gold futures at $1,800 and sell if the price rises to $1,810. | Profit from price fluctuations by predicting market direction. |
| Position holders | Hold futures contracts long-term, regardless of short-term market movements. | Buy gold futures at $1,800 and hold for extended periods. | Maintain positions through market fluctuations for larger gains. |
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Main types of future contracts
Now that you understand what futures contracts are and how they work, we can move on to the typology:
- Commodities Futures. Commodities futures are futures contracts that allow traders to buy or sell commodities like oil, gold, wheat, cotton and natural gas.
- Currency Futures. Futures contracts are exchange-traded futures that determine the value at which one currency can be bought or sold in another currency at a specific date.
- Interest Rate Futures. Futures that allow traders to speculate on or hedge against future changes in interest rates, usually based on bonds.
- Stock Market Index Futures. Contracts based on the performance of a stock market index, like the S&P 500, enable traders to speculate on the overall market’s direction.
Other types of future contracts
Most investors trade with the four aforementioned types of futures. However, the reason for that is mostly popularity. The second reason people might pick commodities, for example, is because of how easy it is to get into it once you’re already a savvy investor. Nevertheless, here are additional types of futures contracts to consider:
- Financial Futures. These cover financial instruments like stock indices (e.g., S&P 500), interest rates, and bonds.
- Crypto Futures. Futures contracts in crypto allow traders to buy or sell cryptocurrencies at a predetermined date and price.
- Energy Futures. These cover energy products such as crude oil, natural gas, and electricity.
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The difference between futures contracts and forward contracts
The main difference between futures contracts and forward contracts is that futures are traded on the exchanges, while forwards are traded directly between two parties over the counter (OTC). Even though they are both based on underlying assets, contractual obligation and a predetermined price on a specified future date, the similarities end there.
Futures are highly standardized contracts traded on exchanges where they are regulated and overseen by government authorities for either speculation or hedging against price fluctuations. On the other hand, forward contracts are customized agreements traded over the counter directly with much less regulation, as they are private agreements with the main goal of hedging specific and less liquid assets.
| Standardization | Highly standardized, with fixed contract terms (size, delivery date, etc.) | Customized to the specific needs of the buyer and seller |
| Trading Venue | Traded on exchanges (e.g., CME, ICE) | Traded over-the-counter (OTC) between two parties |
| Settlement | Can be settled daily (mark-to-market) | Settled at maturity (no daily mark-to-market) |
| Regulation | Regulated by government authorities (e.g., CFTC in the US) | Less regulated, as they are private agreements between parties |
| Liquidity | Generally more liquid due to standardized contracts and exchange trading | Less liquid due to custom terms and private agreements |
| Credit Risk | Lower credit risk due to clearinghouses acting as intermediaries | Higher credit risk since it’s a direct agreement between parties |
| Purpose | Speculation or hedging price risk in liquid markets | Hedging, often for specific and less liquid assets |
The benefits of using futures contracts
The biggest advantage of futures contracts for me is the ability to manage risk and profit from market movements. Those two are not the only ones, of course, but they are the ones most savvy investors are fond of.
- Direct market exposure. Allowing the trader to participate in price fluctuations without owning the underlying asset.
- 24/7 trading opportunities. Traders possess the ability to react to market events at any time of the day providing flexibility to investors.
- Liquidity. Futures markets are highly liquid, meaning you can enter and exit trades easily without major price distortions.
- Regulated & Transparent Markets. CME futures contracts are well-regulated, ensuring fair pricing and reducing counterparty risk.
The drawbacks of using futures contracts
Futures contracts have their pros, but they also have some disadvantages, like all the other investment options:
- High leverage risk. Futures contracts often involve leverage, meaning you can control large positions with a small amount of capital. While this amplifies potential profits, it also increases the risk of significant losses if the market moves against you.
- Market volatility. Futures markets can be highly volatile, with prices often fluctuating rapidly. This can result in unexpected losses, especially for traders who are not well-prepared or experienced.
- Expiration date pressure. Futures contracts come with fixed expiration dates, which may require traders to close or roll over positions at specific times, potentially incurring additional costs.
- Limited flexibility. Futures contracts are tied to specific assets and predetermined delivery dates, which can limit your ability to adjust or adapt your futures trading strategy.
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Bottom Line
Futures contracts allow traders and investors to lock in a price for an asset to be delivered later. These contracts are used to manage risk or to profit from price changes. Traders can use futures to hedge against price fluctuations or speculate on the movement of commodities, currencies or other assets.
To start trading futures, it’s essential to choose the best brokerage accounts. A good broker should offer access to the futures markets you want to trade, charge reasonable fees and provide reliable support. Look for a platform that fits your needs and provides the tools to help you succeed.
Frequently asked questions
What are CME futures contracts?
CME futures contracts are standardized agreements traded on the Chicago Mercantile Exchange (CME), where buyers and sellers agree to exchange assets at a predetermined price and date in the future. In the futures market, assets include commodities (coffee, oil, gold, etc.), currencies, energy, stocks, interest rates, and more.
These contracts cover a wide range of assets, including commodities, stock indices and interest rates.
What is the best cryptocurrency for futures?
The best cryptocurrency comes down to what suits you, your investment portfolio and your personal risk tolerance. However, some cryptocurrencies have a better track record than others.
For example, picking solana, cardano or litecoin for futures contracts in crypto can have fewer risks due to their high liquidity, significant market capitalization and established and continued relevance in the crypto ecosystem. However, cryptocurrency remains a very volatile commodity in the market.
Why is it called a futures contract?
A futures contract is named for the fact that both the buyer and the seller agree on a price today for an asset or security, with the delivery set to occur at a later date.
Why would someone buy a futures contract?
There are two main reasons for futures contracts and futures trading. Risk management, meaning you can hedge against price fluctuation of a certain commodity and secure stable and predictable pricing. The second reason can be that you speculate a certain commodity, security or currency will experience price movement and you believe you can profit from that movement.
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