A futures contract is a standardised agreement traded on an exchange to buy or sell an underlying asset at a set price on a set future date. The underlying can be a commodity, an index, a rate or a currency.
Unlike a one-off private deal, futures are cleared through a central counterparty, settled daily and backed by margin. That structure makes prices transparent and credit risk much lower than in over-the-counter forwards.
What a futures contract actually covers
Each futures market publishes a contract specification so everyone knows exactly what is being traded. The spec sets:
- Underlying and contract size: what the contract references and how much it controls. For example, one equity index contract might represent a set multiple of the index level, while a commodity future might represent a fixed number of barrels, tonnes or bushels.
- Tick size and tick value: the minimum price increment and the cash impact of one tick. These define the smallest possible profit or loss per contract.
- Trading months: which future delivery months are listed (for example, March, June, September and December).
- Settlement type: cash-settled versus physical delivery. Cash-settled contracts convert the price difference at expiry into a payment. Physically settled contracts specify delivery location, grade and timing.
- Last trade date and key times: when trading stops and how the final price is set.
Because the terms are fixed, liquidity can concentrate in a few standard months. Traders who need a different date usually roll from one listed month to the next rather than ask for a bespoke contract.
Margin and daily mark-to-market
Futures use margin rather than full upfront payment. When you open a position, you post initial margin with your broker and must maintain at least a maintenance margin. The exchange’s clearing house re-prices your position each day to the official settlement price and credits or debits your account. This is called variation margin or daily mark-to-market.
The result is embedded leverage. A relatively small deposit controls a larger notional exposure, with gains and losses realised as the market moves. If losses push your balance below maintenance margin, you’ll receive a margin call to top it back up. If you fail to meet it, the broker can reduce or close the position.
Simple illustration: say a contract’s tick value is £10. You buy one contract at 5,000. If the settlement price moves to 5,050 the same day, you’re up 50 points, which is £500. That £500 is credited to your account overnight. If the market falls 60 points the next day, you’re debited £600, and your margin must still meet the minimum.
How futures prices are set: cost of carry
A futures price is linked to today’s spot price by the cost and benefits of holding the underlying until the contract’s expiry. This relationship is often called fair value or cost of carry.
- Financial assets: for an equity index, the price reflects financing costs to hold the basket minus expected dividends over the life of the contract.
- Commodities: for oil, metals or grains, carrying costs include storage, insurance and financing. A hard-to-source commodity can have a convenience yield, which lowers the futures price relative to spot.
When futures trade above spot across the curve, the market is in contango. When they trade below, it’s called backwardation. Neither is good or bad on its own, but it does affect the cost of rolling positions from one month into the next.
What happens at expiry and how settlement works
Every contract has an expiry date. Trading usually stops shortly before or on that date, and the exchange publishes a final settlement price. For many contracts this is the EDSP, a defined calculation based on trades or quotes during a set window, designed to reduce manipulation and reflect the underlying market fairly.
After the final price is set:
- Cash-settled contracts convert the difference between your entry price and the final settlement price into a cash credit or debit and the position ends.
- Physically delivered contracts move into a delivery process where shorts must deliver and longs must take delivery, according to the rules. Most traders who do not want delivery close or roll well before this stage.
Rolling means closing the near-month future and opening the next one, often as a single calendar spread trade. The roll price reflects the difference between the two contracts, which in turn reflects cost of carry and supply-demand in each month.
How futures are used in practice
Hedging: a grain producer can sell harvest-month futures today to lock in a price for expected output. If spot prices fall by harvest time, the lower cash price received is offset by gains on the short futures. A fund manager can sell equity index futures to reduce portfolio sensitivity to a market sell-off without selling the portfolio itself.
Speculation: a trader who thinks a market will rise can buy a futures contract instead of the underlying. The tick-by-tick P&L and the margin framework make it a capital-efficient way to express a view, though losses can exceed the initial deposit.
Arbitrage and basis trading: when the gap between futures and spot deviates from carry logic, arbitrageurs buy one and sell the other to capture the difference. Many participants also run basis positions that balance futures and physical exposure.
Futures, forwards and options: what’s different
Futures are often mentioned alongside forwards and options. They are not the same.
| Feature | Futures | Forwards | Options |
|---|---|---|---|
| Trading venue | Exchange-traded with central clearing | Over-the-counter between two parties | Exchange-traded and OTC exist |
| Customisation | Standardised terms | Fully customisable | Standardised strikes and expiries on exchange |
| Credit risk | Low due to clearing and margin | Counterparty risk until maturity | Varies by venue and issuer |
| Daily settlement | Yes: mark-to-market | No: settled at maturity | Premium paid upfront; payoff at exercise or expiry |
| Obligation | Both sides are obligated | Both sides are obligated | Buyer has the right, not the obligation |
| P&L profile | Linear with price moves | Linear with price moves | Non-linear due to optionality |
Risks, frictions and market quirks
- Leverage cuts both ways: small percentage moves can translate into large gains or losses versus the margin posted. Stops and position sizing matter.
- Basis risk: your cash exposure might not match the futures contract perfectly, leading to imperfect hedges.
- Liquidity and limits: some contracts are thin away from the front month. Many exchanges impose daily price limits that can temporarily cap movement and affect execution.
- Roll costs: in contango, maintaining a long position by rolling forward can be expensive over time. In backwardation, the roll can benefit longs but harm shorts.
- Contract specifics vary: tick values, margin rates, trading hours and delivery rules differ by exchange and product. Always check the official spec before trading.
Put simply, a futures contract turns a view or a hedge into a clear, standardised position with defined mechanics for pricing, settlement and risk control. The details are what make it work, so get familiar with the spec, the margin process and the calendar before you place the first trade.