01The handshake
A corn farmer plants in spring and harvests in the fall. Between now and then the price of corn can rise or fall a long way, and the farmer has loans to pay whichever way it goes. A cereal maker has the opposite worry: it needs corn in the fall and fears the price will rise.
So they shake hands today: in six months the farmer will deliver 5,000 bushels and the cereal maker will pay a price fixed now. Neither pays anything upfront. If corn soars, the farmer misses out but still gets a known price; if it collapses, the cereal maker overpays but knew its cost all along. Both have swapped an unknown price for a known one.
That private handshake is a forward. A futures contract is the same promise made standard and traded on an exchange: every contract has the same size, quality and delivery dates, and a clearinghouse stands between buyer and seller, so neither has to trust the other. Standard terms also mean either side can get out early by making the opposite trade with someone else.
02What is in the contract
Every futures contract names four things: what is traded, how much of it, when the contract ends, and how it settles. Some end with real delivery of the goods; others settle in cash, with no goods changing hands.
| Contract | One contract is | Settles by |
|---|---|---|
| E-mini S&P 500 (CME) | $50 × the S&P 500 index | Cash |
| Micro E-mini S&P 500 (CME) | $5 × the S&P 500 index | Cash |
| Crude oil, WTI (NYMEX) | 1,000 barrels | Delivery |
| Corn (CBOT) | 5,000 bushels | Delivery |
The number that multiplies the price is the contract's multiplier. With the S&P 500 at 6,000, one E-mini controls 6,000 × $50 = $300,000 of stock-market exposure, its notional value. Keep that $300,000 in mind: it is what you are exposed to, whatever you put down.
Very few traders hold to delivery. Almost everyone closes or rolls the position before the contract ends; delivery is there mainly to tie the futures price to the real thing.
03How a position makes money
Buying a contract is going long: you gain when the price rises. Selling a contract, with nothing to own or borrow first, is going short: you gain when the price falls. Every dollar one side makes, the other side loses, before fees. Futures are a zero-sum game between the two parties.
You buy one E-mini at 6,000 and sell it at 6,050. The gain is 50 points × $50 = $2,500. The same 50 points on the Micro contract is 50 × $5 = $250.
Had you been short, you would have lost the same $2,500.
04Margin and leverage
You don't pay $300,000 to hold an E-mini. You post initial margin, a deposit of a few percent of the contract's value, held as a good-faith guarantee that you can cover losses. It is not a down payment: you own nothing yet, and the deposit comes back when you close the trade, plus or minus your gains and losses.
A second, lower line is the maintenance margin. If losses push your account below it, you get a margin call: add cash to bring the account back up to the initial margin, or the broker closes the position for you.
Small deposit, large exposure: that is leverage. With $22,000 posted against a $300,000 contract, every 1% move in the index (60 points, or $3,000) is about 14% of your deposit, and a fall of about 7% would take nearly all of it.
The margin figures in these examples are round numbers for the arithmetic. Exchanges set real margins, change them when markets get rough, and brokers can ask for more.
05Settled every day
Here is what makes futures different from a handshake. At the end of every trading day the exchange sets a settlement price, and every open position is marked to market: the day's gains are paid into winners' accounts and the day's losses are taken out of losers' accounts, in cash, every day. Nobody waits until the end to settle up, so losses can't pile up unpaid for more than a day.
Initial margin $22,000; maintenance $20,000.
| Day | Settles at | Cash moved | Balance | Margin call |
|---|---|---|---|---|
| 1 | 5,980 | −$1,000 | $21,000 | — |
| 2 | 5,950 | −$1,500 | $19,500 | Add $2,500 to get back to $22,000 |
| 3 | 5,930 | −$1,000 | $21,000 | — |
| 4 | 5,990 | +$3,000 | $24,000 | — |
| 5 | 6,040 | +$2,500 | $26,500 | — |
The trade ends 40 points up, a $2,000 gain. But to stay in it you had to find $2,500 of fresh cash on day 2. Traders who couldn't would have been closed out near 5,950 with a $2,500 loss and missed the recovery.
Think of a cash game where every hand is settled as it ends and you must keep a minimum stack in front of you to stay seated. Drop below it and you either reach into your pocket or you're out of the game, even if the cards were about to turn. Being right eventually is worth nothing if you can't afford to stay at the table until then.
06What a futures price should be
If the S&P 500 is at 6,000 today, why might the futures contract for delivery in three months trade at 6,042? Because there are two ways to own the index in three months, and they have to cost the same.
- Buy the stocks now. You pay 6,000 today, give up the interest that cash would have earned, and collect the dividends along the way.
- Buy the futures. You pay nothing now, keep your cash earning interest in a Treasury bill, but get no dividends.
If the futures were cheaper than that comparison says, traders would buy futures and sell the stocks; if dearer, the reverse. That trading, called arbitrage, keeps the futures price pinned to its fair value, which is the spot price plus the cost of carrying the position:
Spot 6,000; interest 4% a year; dividend yield 1.2%; three months (t = 0.25).
6,000 × (1 + (0.04 − 0.012) × 0.25) = 6,000 × 1.007 = 6,042.
The 42-point gap between futures and spot is called the basis. It shrinks as expiry approaches, because there is less time left to carry, and reaches zero at expiry, when the futures and the index must be the same.
Those 42 points are not a forecast that the index will rise. They are the cost of carrying it: the interest the futures buyer keeps earning on cash, less the dividends the futures buyer gives up. Hold the futures while the index stands still and the 42 points melt away as the basis shrinks, a loss on the futures that the interest on your cash pays back. It is also why the stock-index futures levels on The Morning Line usually sit a little above the indexes themselves before the open.
For physical goods, carrying costs include storage and insurance. A barrel of oil sitting in a tank costs money to keep. Against that sits what traders call the convenience yield: the value of having the barrel in hand when supply is short.
07Contango and backwardation
Line up the prices of every delivery month and you get the futures curve. When later months cost more than nearer ones, the market is in contango, the normal state when carrying costs outweigh any income. When later months cost less, it is in backwardation, which usually means the thing is wanted now: supply is tight and holders won't give it up cheaply.
The shape matters to anyone who holds futures for a long time, because contracts expire and must be rolled: sell the expiring month, buy a later one. In contango each new contract is bought above spot and then, if spot stays put, spends its life drifting down toward it, just as the 42 points did above. Roll after roll, that drift can leave a long holder well behind the spot price, even when the spot price ends where it started. In backwardation the drift runs the other way and works in the holder's favor.
08Who is on the other side
- Hedgers use futures to offset a risk they already carry: the farmer and the cereal maker, an airline locking in jet fuel, a pension fund trimming its stock exposure for a few weeks without selling shares.
- Speculators carry no underlying risk; they take a view on the price. They are the counterparties hedgers need, and their trading keeps the market liquid.
- Arbitrageurs watch the gap between futures and fair value and trade it away, which is why the formula above holds so closely.
A hedger who loses money on the futures has usually gained it back on the crop, the fuel or the portfolio. That is the point: the hedge trades the chance of a windfall for certainty. A speculator has no such offset; the futures gain or loss is the whole story.
09What can go wrong
- Losses can exceed the deposit. Margin is a deposit, not a cap. A big enough move can take more than you posted, and you owe the difference.
- Leverage cuts both ways. A move that would be a bad day for a stock investor can wipe out a futures account.
- Forced exits. If you can't meet a margin call, the position is closed at whatever the price is then, often near the worst moment.
- Gaps. Prices can jump overnight or on news, skipping past the level where you meant to get out.
- Roll costs quietly erode long-term positions in contango.