How Futures Contracts Work: A Plain-English Guide

A futures contract is an agreement to buy or sell a set quantity of a commodity or financial instrument at a price fixed today, with delivery or final settlement on a later date. The Commodity Futures Trading Commission (CFTC) glossary describes it as an agreement to purchase or sell a commodity for delivery in the future, one that obligates both sides to perform and that can be satisfied either by delivery or by offset. This guide explains how that works in practice, who uses the futures market, and where beginners most often go wrong.

In brief

• A futures contract fixes a price now for a transaction that completes later.
• Exchanges standardize the terms, so contracts are interchangeable and easy to trade.
• A clearinghouse stands between buyers and sellers and settles gains and losses every day.
• Most positions are closed out before delivery rather than held to the end.
• The same contract serves hedgers, who reduce price risk, and speculators, who accept it.

The basic idea

Imagine a bakery that needs wheat in four months and worries that prices will rise. A grain farmer worries that prices will fall before harvest. Both can agree today on a price for wheat to be delivered later. If they use a futures contract, they do not have to find each other or negotiate terms. They each trade a standardized contract on an exchange, and the price they see is the market’s current agreement on what that future delivery is worth.

The key feature is the obligation. Unlike an option, which gives its holder a right but not a duty, a futures contract binds both the buyer (the “long”) and the seller (the “short”). The buyer is committed to take the commodity or its cash value at the agreed price. The seller is committed to deliver it. What happens to the contract between signing and expiry, though, is where most of the interesting mechanics sit.

What is standardized

Exchanges such as the CME Group’s markets write the specifications of each contract. A typical specification covers:

• The underlying: the commodity, grade, index or financial instrument.
• Contract size: how much of the underlying one contract represents.
• Delivery months: the calendar months in which contracts expire.
• Price quotation and minimum price movement: how prices are stated and the smallest step they can move.
• Settlement method: physical delivery, or cash settlement.
• Last trading day: the date after which the contract can no longer be traded.

Because every contract for a given month is identical, a position opened with one counterparty can be closed with a different one. That interchangeability is what makes futures liquid. For exact specifications, always read the product page on the exchange’s own website, since sizes and months differ by product and can change.

The role of the clearinghouse

When a buy order and a sell order match, the trade does not remain a bilateral deal between two strangers. A clearing organization steps in, becoming the buyer to every seller and the seller to every buyer. The CFTC glossary describes a clearing organization as an entity through which futures and other derivative transactions are cleared and settled, and one that helps ensure proper delivery procedures and adequate financing of trading.

This arrangement matters for credit risk. If your counterparty fails, the clearinghouse, not you, deals with it. In exchange, the clearinghouse requires everyone to post collateral called margin and to settle gains and losses in cash daily. Our guide to margin and leverage in futures trading covers that collateral in detail.

Daily settlement: how gains and losses are paid

Futures accounts are marked to market. At the end of each trading session the exchange determines a settlement price, and every open position is revalued against it. The CFTC glossary defines mark-to-market as the daily cash-flow process that calculates the gain or loss in each contract position resulting from changes in price. Winners are credited and losers are debited the same day.

This is different from owning a stock, where an unrealized loss simply sits on paper. In futures, a loss is a real cash movement out of your account each day. If the balance falls below the required level, the broker issues a margin call and the position may be closed if the account is not topped up.

Delivery, cash settlement and offset

A contract can end in one of three ways.

Physical delivery. For some commodity contracts, a seller still holding at expiry must deliver the commodity, or a delivery instrument such as a warehouse receipt, and a buyer must accept and pay. The CFTC defines delivery as the tender and receipt of the actual commodity, its cash value, or such an instrument.

Cash settlement. Many contracts, including stock index futures, never involve the underlying. At expiry the losing side pays the winning side the cash difference, calculated by the contract’s stated procedure.

Offset. The usual outcome is that a trader closes the position before expiry by taking the opposite trade: someone long one contract sells one contract of the same month, and the obligation disappears. The profit or loss is the difference between the entry and exit prices, already settled through the daily process.

Even speculators who never want a barrel of oil or a bushel of corn can therefore trade these markets safely, so long as they exit before the delivery process begins. Brokers often set their own earlier cutoffs for retail accounts, so check yours.

Why futures prices and spot prices stay linked

The price for immediate delivery is the spot price. The futures price is the price for later delivery. The two are tied by the cost of carrying a physical commodity, which includes storage, financing and insurance, and by expectations about the future. As expiry approaches, the CFTC notes, cash and futures prices tend to converge, a narrowing of the “basis.” If they did not, traders could profit from buying in the cheaper market and selling in the dearer one, which pushes the prices back together.

The shape of prices across delivery months is a topic of its own. Our explainer on contango and backwardation shows how the futures curve is read.

Who trades futures

The U.S. Energy Information Administration (EIA) separates participants in oil futures into two broad groups, and the split applies to most commodity markets.

• Commercial traders are firms with a direct stake in the physical commodity: producers, refiners, airlines, food processors, utilities. The EIA gives the example of an airline buying futures to guard against rising fuel costs, and an oil producer selling futures to lock in a price for future output. This is hedging.
• Non-commercial or financial traders include hedge funds, commodity trading advisors, investment banks and asset managers. They trade the contracts rather than the physical product, taking on price risk in pursuit of profit and often serving as the counterparty to hedgers.

Without speculators, a hedger might struggle to find someone willing to take the opposite side at a fair price. With them, the market is deep enough to absorb large orders.

A worked example (hypothetical numbers)

The figures below are invented to show the mechanics, not to describe any real contract.

Suppose a trader buys one contract for a commodity at 100 per unit, where the contract covers 1,000 units. The contract’s notional value is 100,000.

• At the end of day one, the settlement price is 102. The position gained 2 per unit, or 2,000 in total. That amount is credited to the trader’s account in cash.
• On day two the settlement price falls to 99. The position lost 3 per unit, or 3,000, which is debited.
• On day three the trader sells one contract of the same month at 101 to close out. The final day’s gain, 2 per unit or 2,000, is credited.

Adding the daily flows, the net result is +2,000 − 3,000 + 2,000 = +1,000, which equals the 1 per unit difference between the entry at 100 and the exit at 101, multiplied by 1,000 units. No commodity changed hands. The trader only ever dealt with the broker and the clearinghouse.

Common misconceptions

“Buying a futures contract means buying the commodity.” Not unless held to physical delivery. Most contracts are closed before that point.

“Margin is a down payment.” The CFTC glossary states plainly that margin is not a partial payment on a purchase. It is a performance bond, a deposit that guarantees you can meet your obligations.

“Futures prices predict the future.” They reflect the market’s current consensus, including the costs of carrying the commodity. The EIA notes that futures prices reflect expectations about future supply and demand, which can change quickly when news arrives.

“Only professionals can lose big.” Because a small deposit controls a much larger position, losses can exceed the initial deposit. The CFTC and brokers publish risk disclosures that spell this out.

Where to learn more

The CFTC maintains educational material and a glossary at cftc.gov. The exchanges publish contract specifications, margin schedules and education courses, and the EIA explains how futures interact with physical energy markets. Anyone planning to trade should read the broker’s risk disclosure statement before funding an account.

FAQ

Is a futures contract the same as an option?

No. A futures contract obligates both parties to perform. An option gives the buyer the right, but not the duty, to buy or sell at a set price before a set date, as the EIA explains. Options on futures exist, but they are separate contracts.

Do I have to take delivery of the commodity?

Not if you close the position before the delivery process begins. Many contracts are cash settled, and for physically delivered ones, most traders offset beforehand. Your broker may also require you to exit by a date earlier than the exchange’s last trading day.

What happens to a futures contract at expiry?

The contract stops trading. Physically delivered contracts proceed to delivery under exchange rules, and cash-settled contracts are settled by a final payment based on the contract’s reference price.

Who guarantees that the other side will pay?

The clearinghouse. It becomes the counterparty to both sides of each trade and collects margin and daily settlements to support that guarantee.

How are futures regulated in the United States?

The CFTC oversees futures and derivatives markets, and the exchanges and clearinghouses it regulates set and enforce their own rules. Brokers that handle customer futures accounts are subject to registration and oversight as well. See cftc.gov for details.

Are futures suitable for beginners?

They are complex and leveraged products. This guide is educational only and does not recommend any trade. Anyone considering futures should understand the risk of loss and read the risk disclosures their broker provides.