A futures contract is a standardized, exchange-traded agreement that creates an obligation for one party to buy and another to sell a specified underlying asset at a predetermined price on a specified future date. Contracts are listed and cleared on organized exchanges, which reduce counterparty risk by interposing a clearinghouse between the original buyer and seller. While many contracts result in cash settlement, some provide for physical delivery of the asset at expiry.

Key characteristics

Futures are defined by a small set of contract terms that are uniform for all market participants. These typically include:

  • the underlying asset or index, such as commodities, interest rates or an equity index;
  • the contract size and unit of trading;
  • the delivery month or expiration date;
  • the tick size and price quotation;
  • the method of settlement, and the margining and mark-to-market procedures used daily to manage credit exposure.

Origins and development

Futures markets evolved from earlier commodity trading as producers and merchants sought reliable ways to manage price risk. Over time those arrangements became formalized on exchanges to provide transparent pricing, standardization and an active market for transfer of risk. Today futures exist for a broad range of underlyings, from agricultural crops to energy products and financial instruments such as interest rates and equity indices, and they are traded globally.

Uses and examples

Futures serve several practical roles. Producers and consumers use them to hedge price exposure: for example, a grain farmer may sell futures to lock a price before harvest, while an airline might buy fuel futures to limit its fuel cost. Speculators use futures to take directional positions with leverage, and arbitrageurs exploit price differences between related markets. They also contribute to price discovery by aggregating market expectations about future supply and demand.

Risks and important distinctions

Trading futures involves leverage and daily margining, which can amplify gains and losses and lead to margin calls. Other risks include basis risk (the difference between cash and futures prices), liquidity risk and the possibility of being assigned a delivery obligation. Futures differ from over-the-counter forwards in that they are standardized and centrally cleared, and they contrast with options, which give a right but not an obligation. For more introductory material see how futures work, seller/buyer roles at market participants, examples of price settlement settlement methods, commodity categories like livestock or agricultural produce, and a discussion of trading risks risk considerations.