What Are Futures?

Tyler Stokes

What are futures?

Where do you trade them?

These are the two questions we want to answer in this article. 

This is going to be a very beginner friendly approach to futures. There will be other articles that go into trading futures in more detail.

What Exactly Are Futures?

For this article, I’m going to use “oil” within most of the examples discussed. But you could use any commodity like gold, coffee, soybeans and so on.

Imagine you promise to sell or buy oil at a certain price on a future date, like in three months. That’s what a futures contract is – it’s a promise between two people to trade something at a specific time in the future.

These contracts are usually for things that vary in price, like commodities.


Futures are an agreement between two people to buy and sell something at a future date. 

A futures market exists because there are buyers and sellers that come together to exchange things. These are typically commodities.

Why Use Futures?

  • Hedging: If you’re an oil producer worried about falling prices, you can hedge by using a futures contract. By locking in a selling price for your oil in advance, you ensure a stable income regardless of future market price fluctuations.
  • Speculation: This is like making a guess. Some people buy and sell futures contracts, betting that the price will go up or down. They do this to try to make money from these price changes. This is what day traders do.

Futures vs. Forward Contracts

  • Forward Contracts: These are like special promises made directly between two people or companies. They are not traded on big public markets and are custom-made for what the two parties need. This is called “Over The Counter” (OTC), like a special order you might make at a store, just for you.
  • Futures Contracts: These are like standard promises that are traded on big public markets, where lots of people can buy and sell them. These contracts have rules about size, quality, and when the trade happens. Every day, the market looks at how much these contracts are worth, and people might make or lose money depending on the price changes. This is called “marked to market.”

Real-Life Examples

  • Forward Contract Example: Think of a farmer (Farmer Joe) and a bakery owner (Betty). Joe agrees to sell wheat to Betty at a set price in a few months. This helps Joe know he’ll get a fair price and helps Betty plan her costs.
  • Futures Contract Example: An oil company and an airline make a deal where the company will sell oil to the airline at a set price in the future. This helps both sides plan their finances without worrying about changing oil prices.

Let’s Review This Example a Bit More

The forward and futures contract examples might seem similar at first glance because they both involve agreements to buy or sell something at a set price in the future. However, there are key differences between them:

Forward Contract Example

  • Customization: The agreement between Farmer Joe and Betty is a forward contract. This contract is customized specifically for them. It means they decide the terms like how much wheat and at what price.
  • Private and Direct: This contract is made directly between Joe and Betty, with no involvement from anyone else. It’s like making a deal in a small, private group.
  • Flexibility: Since it’s a private agreement, Joe and Betty can adjust the terms to suit their needs, like changing the amount of wheat or the delivery date.
  • Risk: There’s a bit more risk here because if one of them can’t honor the deal (like if Joe can’t deliver the wheat), there’s no big system in place to help fix the problem.

Futures Contract Example

  • Standardization: The deal between the oil company and the airline is a futures contract. Futures contracts are standardized, which means the terms of the contract, like how much oil and what kind of oil, are set by a big market, not by the two parties.
  • Traded on Exchanges: This contract is traded on a big public market (like a stock exchange), where lots of people can buy and sell similar contracts. It’s not just between the oil company and the airline.
  • Marked to Market: Every day, the value of this futures contract is calculated based on the current market prices. This means the profit or loss from the contract can change every day until it’s completed.
  • Lower Risk: There’s less risk of someone not honoring the deal because the exchange where the contract is traded keeps an eye on things and has rules to manage these risks.

Key Takeaway

The main differences are about how customized the contract is, where it’s traded, and how the risk is managed. Forward contracts are more like personal deals with flexibility but higher risk, while futures contracts are like buying a standardized product from a big store, with rules and systems to reduce risk.

In the example, the oil company and the airline are likely to use the futures contract for actual delivery of oil. However, many traders in the futures market are speculators who have no intention of taking or making delivery of the physical commodity.

How Speculation in Futures Trading Works

Some people, called speculators, trade futures contracts just to make money. They don’t really want the oil or wheat; they just buy and sell the contracts, hoping to buy low and sell high (or the opposite) to take a profit. It’s like betting on which way prices will go.

  • Buying and Selling Contracts: Speculators trade futures contracts on exchanges, just like stocks. They buy a contract if they believe the price of the underlying commodity (like oil) will go up, and sell if they think it will go down.
  • No Physical Exchange: Unlike the oil company and the airline in the example, speculators are not interested in the actual oil. They are only interested in the contract itself and the price changes of that contract.
  • Profit from Price Movements: The goal of a speculator is to profit from short-term price movements. For instance, if a speculator buys an oil futures contract (going long) and the price of oil goes up, they can sell the contract for more than they paid, making a profit. Conversely, if they expect the price to drop, they might sell a contract first (going short) and hope to buy it back later at a lower price.
  • Closing Positions Before Expiry: Speculators usually close their positions before the contract’s expiry date. This means they sell the contract they have bought, or buy back the contract they have sold, before the contract’s delivery date. By doing so, they settle their position in cash, without ever dealing with the physical commodity.
  • Marked to Market: The daily marked-to-market process in futures trading means that the gains or losses from these contracts are settled at the end of each trading day. This process allows speculators to react quickly to price changes and manage their positions accordingly.

An Example of Speculation in Action

Imagine a speculator (trader) thinks the price of oil will rise.

They buy an oil futures contract at the current price. If the price of oil increases the next day, the value of their contract also increases. The trader can then sell the contract for a profit.

If, however, the price of oil decreases, the value of their contract decreases, and they might choose to sell it at a loss to avoid further losses.

When a trader buys an oil futures contract to speculate on the price, they are not buying a contract that already exists between two specific parties. Instead, they are entering into a new contract on a futures exchange.

Here’s what happens:

What is an Oil Futures Contract?

An oil futures contract is an agreement to buy or sell a specific amount of oil at a predetermined price on a specified future date. These contracts are standardized in terms of the quantity of oil (usually measured in barrels), the quality or type of oil, and the delivery date.

You can substitute “oil” with any commodity and the example is the same.

What Happens When You Buy a Futures Contract?

  • Entering a New Contract: When you buy an oil futures contract, you are essentially entering into a new agreement. You agree to buy a set amount of oil at a specified price on a future date. This contract is then matched with another market participant who takes the opposite position (agreeing to sell oil at the same terms).
  • No Physical Exchange Initially: You’re not buying actual barrels of oil; you’re buying the rights and obligations under the contract. Initially, there is no physical exchange of oil. Instead, you’re gaining exposure to the price movement of oil.
  • Trading on an Exchange: This transaction occurs on a futures exchange, a marketplace where traders can buy and sell futures contracts. The exchange ensures standardization and facilitates the trade, acting as an intermediary between buyers and sellers.
  • Margin Account: To buy a futures contract, you don’t pay the full value of the oil upfront. Instead, you pay a margin, which is a fraction of the contract’s total value. This margin acts as a form of security deposit.
  • Speculating on Price Movement: Your profit or loss depends on the price movement of oil. If the price of oil rises above the price at which you agreed to buy it in the contract, you can sell the contract for a profit. If the price falls, you may incur a loss.
  • Closing the Position: Most speculators close their position before the contract’s expiration date. This means they sell the futures contract they have bought (or buy back the contract they have sold) to realize their profits or losses, without ever taking delivery of the actual oil.

Key Takeaway

  • When buying an oil futures contract, you’re not purchasing the physical commodity but rather the rights and obligations of the contract.
  • The contract is a commitment to buy or sell a specific quantity of oil at a predetermined price on a future date.
  • Your goal as a trader is to profit from price changes in oil, and you typically close the position before the contract expires to settle your gains or losses in cash, rather than dealing with the physical oil.

In summary, while futures contracts can be used for actual commodity transactions, they are also a tool for speculators to profit from price movements in the market.

Price Changes in Commodities – What Are You Speculating On?

When day traders buy and sell futures, particularly in the context of commodities, they are essentially speculating (or “gambling”) on the price changes of these commodities. These price changes can be influenced by a variety of factors:

  1. Supply and Demand: The most fundamental factor. If a commodity is in high demand and low supply, its price is likely to increase. Conversely, if there’s more supply than demand, prices might drop.
  2. Economic Indicators: Economic data such as GDP growth rates, employment figures, and inflation rates can impact commodity prices. For example, strong economic growth can lead to higher demand for commodities.
  3. Geopolitical Events: Political events, wars, or conflicts, especially in regions crucial for the production of a commodity, can affect its supply, thereby impacting prices.
  4. Weather and Natural Disasters: For agricultural commodities, weather conditions play a significant role. Droughts, floods, or other extreme weather can impact crop yields, affecting supply and prices.
  5. Currency Fluctuations: Since commodities are often priced in U.S. dollars, changes in the value of the dollar can affect commodity prices. A weaker dollar can make commodities cheaper in other currencies, potentially increasing demand.
  6. Market Sentiment: Traders’ perceptions and expectations can drive prices independently of supply and demand fundamentals.
  7. Government Policies and Regulations: Policies related to trade, tariffs, and subsidies can influence commodity prices. For example, a new tariff on a commodity might reduce its demand, lowering prices.
  8. Technological Changes: Advances in technology can affect production costs and efficiency, impacting the supply side of commodities.

Day traders in the futures market try to predict these changes and make quick decisions to buy or sell futures contracts, hoping to profit from short-term price movements.

However, it’s important to note that this kind of trading involves high risk and requires a good understanding of the market and the factors that influence it.

Key Insights

  • Futures Contracts Defined: Agreements to buy or sell commodities like oil or crops at a future date for a predetermined price.
  • Purpose of Futures:
    • Hedging: Protects against price volatility, useful for farmers and manufacturers.
    • Speculation: Traders predict price movements to make profits.
  • Differences Between Futures and Forward Contracts:
    • Forward Contracts: Customized, private agreements not traded on public markets, with higher flexibility and risk.
    • Futures Contracts: Standardized, publicly traded on exchanges, marked to market daily, offering lower risk.
  • Speculation in Futures Trading:
    • Speculators buy and sell futures to profit from price changes without intending to handle the physical commodity.
    • Positions are typically closed before contract expiration to settle profits or losses.
  • Buying a Futures Contract: Involves entering a new agreement on a futures exchange, with no initial physical exchange of the commodity.
  • Factors Influencing Commodity Prices: Supply and demand, economic indicators, geopolitical events, weather and natural disasters, currency fluctuations, market sentiment, government policies, and technological changes.
  • Trading Risks: Futures trading involves significant risk and requires understanding market influences and price movements.

About the author

Hi I'm Tyler Stokes. I started my day trading journey in 2024. As a pure beginner I decided to document everything on this website. I plan to share all the ups and downs of becoming a day trader on this website and through social media.