Futures are a type of derivative, which means they “derive” value from price fluctuations of an underlying financial instrument or set of assets, such as an index. The underlying instrument can be anything—stocks, bonds, precious metals, commodities, currencies, even interest rates.
A futures contract is simply an agreement between a buyer and a seller in which the buyer commits to paying a certain price for a certain asset on a certain date, and the seller agrees to deliver the asset according to the contract terms. Unlike options, which grant the owner the right, but not the obligation, to buy an asset, futures are legally binding, and the purchaser must buy the underlying asset for the agreed-upon price at the date of expiry. Some futures are settled in cash and some are settled by physical delivery of the asset.
Businesses frequently use futures to hedge against underlying price fluctuations in a commodity that affects their operations. For example, if FedEx anticipates an uptick in oil prices, it might lock in fuel prices for its fleet by purchasing a three-month futures contract for a million gallons of gas at $2.50 a gallon. On the other end of the transaction is an oil and gas distributor who needs to ensure a steady market for gas, so he sells FedEx a futures contract with an agreement to physically deliver the gas in three months.
Institutional and retail investors generally aren’t interested in taking delivery of goods; they make money betting on price movements. If the price is below the agreed upon price in the futures contract, the seller makes money. If the price is higher, the buyer makes money. Institutional investors dominate the futures market, although E-mini futures are popular with day traders.
Margin requirements are one of the main obligations for investors who trade in futures. The exchanges set margin rates, although brokers may add an extra premium to offset risk, usually based on factors such as your experience with futures, your income and net worth, and how easy it is to get in touch with you. Most brokers require a significant initial investment to open a futures account; it’s not uncommon to see $10,000 account minimums.
In the equities market, you can trade up to 50% on margin, i.e. you can buy and sell $20,000 worth of stock with $10,000 in your account. The futures market is massively leveraged compared to the equities market, with futures margin rates in the 5% to 15% range. In a futures contract with 10:1 leverage, for example, you can buy and sell assets worth $100,000 with $10,000, and a 5% price shift means a 50% gain or loss on your investment. Futures carry a much higher level of risk.
There are initial and maintenance margins with futures contracts. It works like this: Imagine you hold 10 futures contracts with an initial margin of $25,000 and a maintenance margin of $20,000. As long as the value of your account stays within that $20,000 to $25,000 range, you’re fine. But if the price drops 7%, bringing your account balance to $18,000, you’ll get a margin call and you’ll have to deposit enough money to bring your account balance up to the original margin requirement, or $7,000. If you don’t deposit the money quickly enough, the broker closes your position for you and locks in that $7,000 loss.
To sum up, people who trade in futures are obligated to buy and sell the underlying instruments, whether they are stocks, commodities, or other assets, on the date of expiration. They are also required settle the contract according to the terms, either a cash settlement or physical delivery of goods. And finally, they are obligated to maintain an adequate amount of cash in their margin account or risk premature closing of the position at a loss.