Futures contracts | Learn their importance in hedging risk and speculation.

Futures contracts are agreements between two parties to:

buy or sell an asset
at a specific price
on a specific date in the future

When we say buy or sell an asset, we refer to any financial asset like oil, gold, wheat, coffee, indices like the S&P 500 or the Dow, cryptocurrencies and other similar financial products.

What we should take from this, is that the settlement price is agreed today, but the actual settlement is yet to come. To grasp the idea better, think of a “now” moment, a spot transaction where settlement is technically T+2 days, and settled immediately in cash. Futures contracts don’t settle in the “now” moment in cash, but at a later day (in 1 month, 3 months, 6 months etc)

Why do futures contracts exist?

Futures contracts are derivative products. As such and like all derivative products, they are mainly used for two reasons. To hedge / reduce exposure, and of course to ride price waves and capitalize on their movements.

To reduce exposure and risk (hedge)

Imagine you are a farmer growing wheat. You are worried that the price of wheat might fall by the time you harvest it in six months, due to geopolitical uncertainties.

To protect yourself from this, you sign a futures contract to sell your wheat at $6 per bushel in six months.

If you are correct and prices fall to $4, you’ve protected yourself against the drop.
If prices rise to $8, you might think you missed the extra profit, but you avoided the opposite scenario, reducing your exposure.

Bottom line is that although the extra profit is welcome, the price agreed when the contract was signed was an acceptable price, based on the costs and margins calculated at the time.

To capitalize on price moves (speculation)

Some traders don’t grow wheat or use oil. They simply want to predict whether prices will go up or down and use the supply and demand dynamics created by those who do want to settle, to capitalize on the price moves.

If they guess correctly, they make money.
If they guess wrong, they lose money.

This summarizes the concept of speculation. Important to note, that speculation is still a guess, and at its best form is an educated guess. Through fundamental and technical analysis, traders bring themselves as close to a correct prediction as they can possibly be. Anything else, like wild guesses, hunches, and wild goose chases, fall in the realm of gambling.

How do futures markets work?

Futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME).

In a quick summary, here’s how the process works:

Buyers and sellers agree on a futures price.
The exchange acts as a middleman to make sure both sides follow the rules.
Both sides deposit collateral money, also known as margin to lock the deal in.
Profits and losses are calculated daily (mark-to-market).
On the settlement date, the contract is closed or settled.

Most futures contracts are never used to actually deliver goods. Instead, traders close their positions before the contract expires.

Futures: Key terms

All futures contracts require a buyer and a seller.

Long Position

If you buy a futures contract, you are said to go long.
You expect the price to go up.

Short Position

If you sell a futures contract, you go short.
You expect the price to go down.

All futures contracts also require a collateral and a settlement date/type.

Margin is a small deposit required to open the contract.

Initial margin is the amount required to open a position.
Maintenance margin is he minimum amount that must stay in your account.

Note: If your account falls below the maintenance margin, the broker house will send you a margin call (usually on the position in the system), that alerts you to add more money. If not, the position will be closed by the system.

Settlement is how futures contracts end.

Physical settlement when the actual asset is delivered (like oil or wheat).
Cash settlement when no asset is delivered. Instead, profits and losses are paid in cash.

Calculation examples (including two examples, one with and one without cost of carry)

Cash settlement: Simple example using gold futures. Hypothetical numbers:

Current gold futures price = $2,000 per ounce
Contract size = 100 ounces
Total contract value = Futures price x contract size (2,000 x 100 = 200,000)
Margin requirements = 5%
Margin = 200,000 x 5% = 10,000
To open a 200,000 value contract, you only need 10,000
- Note: To find the leverage in this example: 200,000 / 10,000 = 20
- So this contract is leveraged 20:1 or 20 times.

If you buy the contract and:

price rises to 2,050, you profit 50 x 100 = 5,000. That’s a 50% return on your 10,000.
Price drops to 1,950, you lose 50 x 100 = 5,000. Also 50% on your 10,000.

Physical settlement: Example using gold futures contracts with carry costs

We want to estimate a 3-month futures price based on today’s spot price and carry costs (interest + storage). We’ll use the cost-of-carry model.

Spot price of gold (price today) ≈ $5,007.70 per ounce.
For commodities, a basic cost-of-carry pricing formula is: F₀ = S₀ x e^{(r + c) x T}

Where:
F₀= theoretical futures price
S₀= current spot price
e = 2.71828 (the base of natural logarithms)
r = annual risk-free interest rate
c = annual storage cost (as a % of spot price)
T = time to expiration (in years)
Assumptions for the example
- Spot price of gold = $5,007.70/oz
- Time to contract expiry = 3 months (0.25 years)
- Risk-free interest rate = 5% per year (typical U.S. short rate)
- Storage cost = 0.5% per year (approx. for bullion storage)
- Convenience yield = 0 (for simplicity here)

Calculation:

Add interest + storage rates

Interest (5%) + storage (0.5%) = 5.5% total annual cost
r + c = 0.05 + 0.005 = 0.055

Multiply by time to maturity

(r + c) x T = 0.055 x 0,25 = 0.01375

Use the futures pricing formula

F₀ = S₀ x e^{(r + c) x T} = 5,007.70 x e⁰¹³⁷⁵
- Use a calculator to find e⁰¹³⁷⁵ = 1.01384
F₀ = 5,007.70 x 1.01384 = 5,076.93

What this means is that the theoretical futures price for a 3-month gold contract is about $5,076.93 per ounce. Holding (or carrying) gold for 3 months, including interest and storage, would cost around $69.23 per ounce above the spot price today.

Why futures contracts matter in our day to day

So many examples we could list like farmers locking in prices, or the airline example above locking fuel prices to protect against uncertainty. Companies dealing with international markets can manage intense currency fluctuations and so on.

At the same time, futures prices are direct reflections of expectations about the markets. They reflect what traders believe a commodity (or other) will cost months from now.

Are futures contracts risky?

Absolutely. All traded financial products and instruments pose risk, especially if guesses are uneducated and accidental. Beginners especially should look into what every position is telling them in terms of leverage, margin, risk tolerance and appetite.

Large profits can amass quickly because of leverage, but so can losses. Accounts can be wiped out in a single move, so protecting your asset with knowledge is of utmost importance. Use risk limits, stop-loss and take-profit orders and size the positions carefully. And these, outside the regular check of fundamentals and technicals to secure proper entry and exit levels.

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.

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