A futures contract is an agreement between two parties to engage in a transaction in the future at a predetermined price. For example, Joe may agree to buy 100 apples from Tom in 30 days at a price of $0.50 per apple. After 30 days pass, Joe must buy the apples from Tom for the agreed $0.50 per apple, regardless of the market price of apples at the time.
In futures contracts, the asset to be transacted by the parties is called the underlying asset; in the above example, the underlying asset would be apples. The settlement date is the date in which the parties agree to make the transaction. The time to maturity of a futures contract is the time remaining until the contract expires. The expiration date of a contract is the date the contract stops trading.
The buyer of a futures contract takes a “long position” in the futures contract, and agrees to purchase the underlying asset at a future date for a predetermined price. The seller of a futures contract takes a “short position” in the futures contract, and agrees to deliver the underlying asset at a future date for a predetermined price. In order to exit a long position, an investor would enter a short position in the same contract, and in order to exit a short position they would enter a long position in the same contract.
Futures exchanges such as the CME offer standardized contracts which offer high liquidity. Standardized contracts specify the settlement method, the units per contract, and the minimum price fluctuation, among other things. For example, soybean futures contracts in the CME have contract sizes of 5,000 bushels, are settled through delivery, and have a minimum fluctuation of $12.50 per contract.
In order to better understand futures contracts, let’s take a real-life example using soybean futures. Suppose we are in August 2016 and we are interested in purchasing a single soybean futures contract which matures in November 2016. We check the CME website and see that the last price quoted for the November 2016 contract is 950. What is the value of one contract? What happens to the value of your futures contract if the price of soybeans changes?
CME soybean futures contracts are quoted in cents per bushel, and each contract is for 5,000 bushels. Since the November 2016 contract is quoted at 950, one contract represents $9.50 x 5,000 = $47,500. However, we don’t have to put up $47,500 – investors must only cover the “margin” costs which are specified by the exchange. In this case, the required margin s $3,100.
If the price of the purchased futures moves above $9.50, the position would have a gain equal to the difference between the current price and the purchase price. If the price of the contract falls below $9.50, the futures contract would incur a loss. Although gains and losses for many securities are not realized until the security is sold (or purchased if holding a short position), futures contracts are “marked to market” which means that gains and losses are realized continuously. The required margin helps to ensure that there are at least some funds available in case an investor suffers mark-to-market losses.