Futures contracts basics: what they are and who uses them

A futures contract is an agreement to buy or sell a specific asset at a set price on a set future date. Unlike buying a stock, which transfers ownership today, a futures position is a commitment about tomorrow. You may see "stock futures are up" in the morning news because index futures trade when the stock market is closed, which makes them a common early read on sentiment.

How a futures contract works

A futures contract is standardized and traded on a regulated exchange. The exchange fixes the terms, so that every contract for the same product is identical:

• Underlying: what the contract is based on, such as a stock index, crude oil, gold, wheat or a currency.
• Contract size: how much of the underlying one contract covers.
• Expiration: when the contract ends. Stock index futures use a quarterly cycle of March, June, September and December.
• Tick size: the smallest price move and its dollar value.
• Settlement: physical delivery of the asset, or a cash payment. Stock index futures are cash-settled, and most speculative positions are closed before expiration anyway.

A clearing house stands between buyer and seller, which largely removes the worry that the other side will not pay. To protect itself, it requires both sides to post a margin deposit, sometimes called a performance bond. This is not a loan, as it is in a stock margin account. It is a good-faith deposit, typically a small fraction of the contract's total value, and it is adjusted by the exchange as volatility changes.

Futures are also marked to market daily. Gains and losses are credited and debited to your account each day, rather than only when you close the position. If losses push your balance below the maintenance level, you must add funds promptly or the position is closed.

Futures versus options

An option gives its buyer a right, and the most the buyer can lose is the premium. A futures contract is an obligation for both sides, with no upfront premium, and losses can exceed the margin posted. See options basics.

Who uses futures

• Hedgers want to lock in or reduce price risk. A farmer might sell wheat futures to fix a selling price, an airline might buy fuel futures, and a portfolio manager might sell index futures to reduce exposure to a falling market without selling the stocks.
• Speculators take on price risk hoping to profit, and they supply much of the trading activity that hedgers rely on.
• Arbitrageurs trade the gap between a futures price and the price of the underlying, which keeps the two closely linked.

Example (illustrative numbers)

The E-mini S&P 500 futures contract is worth $50 times the index level. The smaller Micro E-mini version is worth $5 times the index. Assume, purely for illustration, that the index futures price is 5,000.

Contract value = Index level x Multiplier
               = 5,000 x $50 = $250,000
Value of a 1% move = 50 points x $50 = $2,500 per contract

Suppose the exchange margin on that contract were $12,500, which is 5% of its value. A 1% move in the index is then $2,500, or 20% of the margin deposit. The gain or loss is settled in cash that same day. That is leverage: a small deposit controls a large exposure, so percentage gains and losses on the deposit are much larger than the index move. See margin and leverage.

How futures prices relate to spot prices

The futures price generally tracks the current (spot) price of the underlying, adjusted for the cost of holding it until expiration:

Futures price is approximately Spot price + Financing cost - Income from the asset

For a stock index, the income is the dividends the stocks pay, and the financing cost is interest. For commodities, storage and insurance also matter. When futures trade above spot the market is said to be in contango, and below spot, in backwardation. Products that hold futures and roll them into later months can see returns that differ from the spot price because of these gaps.

Why stock investors watch index futures

Index futures trade for nearly 24 hours on business days, so they react to overnight news before the cash market opens, much like the extended sessions described in pre-market and after-hours trading. They track benchmarks such as the S&P 500. They are a reading of current expectations, not a forecast. Futures can move against the previous night's direction by the time the regular session opens.

Common mistakes

• Underestimating leverage. A move far smaller than the margin percentage can wipe out a deposit.
• Ignoring expiration and rolling costs.
• Treating futures as a prediction. They reflect today's expectations and respond to news.
• Assuming losses are capped at the margin. They are not.
• Overlooking contract size. One contract can represent hundreds of thousands of dollars of exposure.

Where this fits on StocksXray

Futures are generally regarded as an advanced product, and StocksXray does not carry futures or options data. The site stays focused on stocks, with market-level context in Market Compass.

Key takeaways

• A futures contract is a standardized obligation to buy or sell an asset at a set price on a future date.
• Margin is a small good-faith deposit, and gains and losses are settled every day.
• Hedgers use futures to reduce price risk, and speculators take the other side hoping to profit.
• Leverage makes futures powerful and dangerous, and losses can exceed the deposit.