Futures Definition

What are Futures?

Futures are derivate financial instruments that obligate buyers and sellers to buy or sell the underlying product at a specific future date and price.

There is a wide variety of underlying assets that can be traded in Futures. For example Stock indices such as the S&P 500 and commodities like Crude Oil, Coffee or Soybean.

Contracts and Expirations

Futures consist of a series of individual contracts with different expiration dates. When the expiration date of a contract is reached then the positions of buyers and sellers are settled according to the contract's definition.

For example: Coffee C Futures (KC) have contracts that expire in March, May, July, September and December of every year. Each of these contracts can be traded separately and often simultaneously.

Contract Selection

At any point in time Futures have a so-called front contract. This is the contract that is most actively traded at that time - which is indicated by its trading volume. In many cases the front contract will be the contract with the nearest expiration date.

Physical Delivery vs. Cash Settlement

At expiration a futures contract can either be cash settled or physically delivered. Cash settlement works by simply debiting or crediting the holder of the position with the difference between its initial price and the final settlement price. Whereas physically delivered products have to actually be ... well ... delivered physically.

Many brokers have their own rules in place to avoid physical delivery of products traded via Futures. As an example, Interactive Brokers will forcefully close out and liquidate positions in physically delivered Futures contracts as their expiration dates approach.

Buy And Sell

You are also not required to hold a Futures contract until it expires. A popular trading strategy is to simply buy or sell a Futures contract and then to sell or buy it back at a profit. Investors can therefore use these contracts as an instrument to speculate on price changes of their underlying asset.

Contract Rolling

Futures positions that should be held longer term can also be rolled forward. Rolling describes the act of closing a position in the currently traded Futures contract and then opening the same position in the new front contract. This is done in order to avoid contract expiration but also to ensure maximum liquidity by staying in the most actively traded contracts.

Leverage

Futures contracts provide traders with high leverage. That means that you can control large contract values with a relatively small amount of capital. This required capital is called initial margin and is usually just a fraction of the real contract value. This leverage allows investors to make more efficient use of their capital and achieve higher gains compared to trading e.g. regular Stock contracts without leverage.

Margin and Risks

Margin requirements for Futures contracts are constantly shifting as a reaction to current market conditions. A leveraged position in the market therefore also comes with certain risks. If you are in a losing position then the margin required to hold that position can increase substantially. If the available funds in the account drop below the minimum required margin - also known as maintenance margin - then a margin call will occur.

A margin call is your broker's demand to add captital or securities to your account in order to raise your account margin to the minimum required level. If this demand is not met then your broker may forcefully close your positions - regardless of their current market price. This often leads to undesirable conditions and losses.