What Are Futures?

Futures are derivative financial contracts that obligate the parties to transact an
asset at a predetermined future date and price. Here, the buyer must purchase or
the seller must sell the underlying asset at the set price, regardless of the current
market price at the expiration date.

Underlying assets include physical commodities or other financial instruments.

Futures contracts detail the quantity of the underlying asset and are standardized
to facilitate trading on a futures exchange. Futures can be used for hedging or
trade speculation.

KEY TAKEAWAYS

 Futures are financial contracts obligating the buyer to purchase an asset or

the seller to sell an asset and have a predetermined future date and price.
 A futures contract allows an investor to speculate on the direction of a
security, commodity, or a financial instrument.
 Futures are used to hedge the price movement of the underlying asset to
help prevent losses from unfavorable price changes
utures Explained
Futures—also called futures contracts—allow traders to lock in a price of the
underlying asset or commodity. These contracts have expirations dates and set
prices that are known up front. Futures are identified by their expiration month.
For example, a December gold futures contract expires in December. The term
futures tend to represent the overall market. However, there are many types of
futures contracts available for trading including:

 Commodity futures such as in crude oil, natural gas, corn, and wheat
 Stock index futures such as the S&P 500 Index
 Currency futures including those for the euro and the British pound
 Precious metal futures for gold and silver
 U.S. Treasury futures for bonds and other products

It's important to note the distinction between options and futures. Options

contracts give the holder the right to buy or sell the underlying asset at expiration,
while the holder of a futures contract is obligated to fulfill the terms of the

contract.

Pros

 Investors can use futures contracts to speculate on the direction in the

price of an underlying asset
  Companies can hedge the price of their raw materials or products they sell
to protect from adverse price movements

 Futures contracts may only require a deposit of a fraction of the contract

amount with a broker

Cons

 Investors have a risk that they can lose more than the initial margin
amount since futures use leverage

 Investing in a futures contract might cause a company that hedged to miss

out on favorable price movements

 Margin can be a double-edged sword meaning gains are amplified but so

too are losses

Using Futures
The futures markets typically use high leverage. Leverage means that the trader
does not need to put up 100% of the contract's value amount when entering into
a trade. Instead, the broker would require an initial margin amount, which
consists of a fraction of the total contract value. The amount held by the broker
can vary depending on the size of the contract, the creditworthiness of the
investor, and the broker's terms and conditions.

The exchange where the future trades will determine if the contract is for physical
delivery or if it can be cash settled. A corporation may enter into a physical
delivery contract to lock in—hedge—the price of a commodity they need for
production. However, most futures contracts are from traders who speculate on
the trade. These contracts are closed out or netted—the difference in the original
trade and closing trade price—and are cash settled.

Futures Speculation
A futures contract allows a trader to speculate on the direction of movement of a
commodity's price.

If a trader bought a futures contract and the price of the commodity rose and was
trading above the original contract price at expiration, then they would have a
profit. Before expiration, the buy trade—long position—would be offset or
unwound with a sell trade for the same amount at the current price effectively
closing the long position. The difference between the prices of the two contracts
would be cash settled in the investor's brokerage account, and no physical
product will change hands. However, the trader could also lose if the
commodity's price was lower than the purchase price specified in the futures
contract.

Speculators can also take a short or sell speculative position if they predict the
price of the underlying asset will fall. If the price does decline, the trader will take
an offsetting position to close the contract. Again, the net difference would be
settled at the expiration of the contract. An investor would realize a gain if the
underlying asset's price was below the contract price and a loss if the current
price was above the contract price.

It's important to note that trading on margin allows for a much larger position than
the amount held by the brokerage account. As a result, margin investing can
amplify gains, but it can also magnify losses. Imagine a trader who has a $5,000
broker account balance and is in a trade for a $50,000 position in crude oil.
Should the price of oil move against their trade, they can incur losses that far
exceed the account's $5,000 initial margin amount. In this case, the broker would
make a margin call requiring additional funds be deposited to cover the market
losses.

Futures Hedging
Futures can be used to hedge the price movement of the underlying asset. Here,
the goal is to prevent losses from potentially unfavorable price changes rather
than to speculate. Many companies that enter hedges are using—or in many
cases producing—the underlying asset.

For example, a corn farmer can use futures to lock in a specific price for selling
their corn crop. By doing so, they reduce their risk and guarantee they will
receive the fixed price. If the price of corn decreased, the company would have a
gain on the hedge to offset losses from selling the corn at the market. With such
a gain and loss offsetting each other, the hedging effectively locks in an
acceptable market price.

How Do Futures Contracts Work?

Regulation of Futures
The futures markets are regulated by the Commodity Futures Trading
Commission (CFTC). The CFTC is a federal agency created by Congress in
1974 to ensure the integrity of futures market pricing, including preventing
abusive trading practices, fraud, and regulating brokerage firms engaged in
futures trading. 

Choosing a Futures Broker

Investing in futures or any other financial instruments requires a broker. Stock
brokers provide access to the exchanges and markets where these investments
are transacted. The process of choosing a broker and finding investments that fit
your needs can be a confusing process. While Investopedia can't help readers
select investments, we can help you select a broker.