A futures contract is an agreement to buy or sell a specific amount of a commodity or financial instrument at a specific price on a specific date in the future. To help you understand why businesses and individuals trade futures, let’s examine how futures contracts can be used, the key components that make up a contract, and how much it costs to trade a futures contract.
One use of a futures contract is to allow a business or individual to navigate risk and uncertainty. Prices are always changing, but with a futures contract, people can lock in a fixed price to buy or sell at a future date. Locking in a price lessens the risk of being negatively impacted by the price change. Let’s look at how this might work for businesses using the coffee industry as an example. If the price of coffee beans goes down, it’s good news for coffee shops but bad news for coffee farmers. However, if the price of coffee beans goes up, the tables turn. With coffee bean futures, both coffee producers and coffee users are able to lock in prices ahead of time.
Now let’s look at how this might work for individuals. Say you’re looking to buy a new home in a year, and you’re afraid interest rates might rise and increase your mortgage payment. You could offset a potential interest rate increase by trading interest rate futures such as the 30-Year U.S. Treasury Bond, or 10-Year Treasury Note, depending on your time horizon.
Five keys components of a contract.
Now that you know how a futures contract is used, let’s look at five key components of a contract. These are also known as standard contract specifications:
Futures markets are open virtually 24 hours per day, 6 days per week; however, each product has its own unique trading hours.
the tick size
Tick size is the minimum price increment a particular contract can fluctuate. Tick sizes and values vary from contract to contract.
Each commodity or financial instrument has a standardized contract size that doesn’t change.
For example, one contract of crude oil always represents 1,000 barrels. One contract of gold futures represents 100 troy ounces. And one contract of E-Mini S&P; 500 futures represents $50 times the price of the S&P500® Index.
Finally, there’s delivery.
Contracts are either financially settled or physically settled. Financially settled futures contracts expire directly into cash at expiration. This includes products like the E-mini S&P; 500 index futures. Physically settled futures contracts expire directly into the physical commodity. This includes products like crude oil.
Now, to understand how much it costs to trade a futures contract, let’s look at an example. Suppose a crude oil futures contract is trading at $50. At this price, 1,000 barrels of crude oil would cost $50,000. But, a trader doesn’t actually have to come up with this amount.
With a futures contract, a trader could control the $50,000 worth of crude oil with just a small deposit. This deposit is called the initial margin requirement, and it refers to the minimum amount of funds a trader needs to enter into a futures contract.
The initial margin requirement is set by the exchange and subject to change but in our example we’ll say that to purchase one crude oil futures contract, the trader had to put up $3,000 for margin to control nearly $50,000 in oil.
As you can see, futures can allow you to leverage a relatively small amount of capital to control a larger underlying asset. Because of this leverage, small changes in the price of the underlying asset have a much larger impact on the futures contract.
Keep in mind that although leverage allows for strong potential returns, it can also result in significant losses. And if losses are substantial, you will have to add more money to cover losses.
Now you know how futures contracts can be used, what the contract specifications are, and how much futures contract costs.