What is a futures contract?

What is a futures contract?

A futures contract is a legally binding agreement to buy or sell an asset at a predetermined price on a specific expiry date. The buyer of a futures contract has the obligation to receive the underlying asset, while the seller is obliged to part with their asset for the contracted price.

Futures contracts are typically traded on exchanges, which means they are highly regulated and standardised to ensure the same quality and quantity per contract. While they’re commonly associated with commodities trading, there are other asset classes available to you including indices.

Futures contracts are often contrasted with spot contacts, which enable you to exchange at the current market price – or ‘on the spot’ – rather than on a date in the future. In a spot contract, you would have the same settlement opportunities as futures.

Futures are also compared to options, as both contract types enable you to buy and sell an underlying asset for a specific price on a future date. However, unlike futures, options contracts, give the buyer the right to leave the contract to expire worthless – they are not obliged to fulfil the contract at expiry.

You can also trade futures, options and spot prices using derivative products, such as CFDs. You wouldn’t be entering into the underlying contacts themselves, but rather speculating on whether the market will rise or fall in price.

Ready to trade futures? Open an account with us today or practise trading in a demo account.

How do futures contracts work?

Futures contracts work by tracking the spot price of an underlying market and taking other factors into account, such as volatility, the time until delivery, interest rates and the costs of maintaining a position – known as the cost of carry.

Futures prices are often higher than the spot price as it adds in all these factors. In this circumstance, the market is said to be in contango. Alternatively, when futures prices are lower than the spot price, the market is in backwardation. When a futures contract expires, it will be equal to the spot price.

At expiry, you could choose to roll your contract and continue to hold the position. Otherwise, you would have to settle your futures contract using one of two methods: physical or cash settlement.

Physical settlement involves taking delivery of the asset in question – this is common for businesses who rely on commodities or deal in currencies. For example, say an airline wants to lock in the price of fuel to avoid an increase in costs, they could buy a futures contract for a set amount of fuel at a set price for delivery in the future.

Not everyone involved in the futures market will be looking to exchange the underlying asset at expiry, so they’d settle in cash instead. This is commonly used among speculators and hedgers who want to take a position on whether the market price will rise or fall, without having to take ownership of the asset itself. The only thing that would exchange hands is the equivalent amount of money.

The sheer number of speculators and hedgers makes the futures market extremely liquid but volatile. The fast changing prices can lead to risks, such as slippage – the potential for your order to be executed at a price that differs from the one you requested. This makes it important to have a risk management strategy in place.

With us, you could attach a guaranteed stop, that will remove the risk of slippage entirely. These stops are free to attach, and will only incur a small premium if triggered.

Learn more about managing your risk

How can you trade futures?

You can trade futures contracts via a broker’s execution platform. You’ll need to analyse the market and decide which futures contract you want to trade, at which expiry date. A lot of speculators will use the nearest date of expiry, as although it’s often the most expensive, it is also the most actively traded and liquid.

Once you’ve entered an futures contract, you’ll be obliged to uphold your side of the deal – whether that’s buying or selling the underlying asset. At expiry, you’d either settle or roll over your contract.

Alternatively, you could trade futures via CFDs, in the same way as any other market. Our futures markets are designed to replicate the pricing and expiry dates of the underlying market, without you having to enter into a futures contract yourself.

You’d be placing a bet on whether the price of futures will rise or fall before a set date, and your profit would be determined by the extent to which you were correct. At expiry, we’d automatically roll your trade over, unless you tell us otherwise.

We also offer mini futures, which enable you to take a smaller position than the standardised agreements.

Example of a futures contract

Say you want to buy US Crude – currently trading at $50. To hedge against the price rising, you opt to buy a July WTI futures at $50. At the time of expiry, the price had risen which means you could buy 1000 barrels of oil at the agreed price, regardless of its current value. However, if the price at fallen, you would be obliged to settle your contract at $50, even if the new market price was lower.

Alternatively, you could open a long CFD position on US crude futures with an expiry date for the end of the month. If the price of crude oil futures had risen at the expiry, you’d make a profit. However, if the price of oil declined instead, you’d have made a loss.