A futures contract obligates an investor to buy or sell the underlying asset at some future date for a price specified today. Originally, the underlying assets for futures contracts were agricultural products (e.g., wheat, orange juice, and pork bellies) and minerals (copper, gold, and heating oil), but the futures market has expanded, and you can buy or sell futures on foreign currencies, interest rates, stock market indices, and even stock options. Retail investors can use futures contracts both to hedge risk and earn speculative profits, but they must be knowledgeable regarding the nuances of the futures markets before they can do so.
Like stocks and stock options, futures contracts trade on exchange floors, but futures trade on their own exchanges, and there are a number of differences in the manner in which these contracts are traded. One significant difference is that while stock prices are able to fluctuate daily without limit, futures contract prices have an established daily limit, and once that limit is reached, trading in the contract ceases for the day. This means that you’re out of luck for the remainder of the day if you want to buy or sell that contract in order to execute a reversing trade, which you must do to get out of a contract. You can’t simply let a futures contract expire as you can an option. These price fluctuation limits are different for each underlying asset, and you need to be aware of the daily limit for any contract you enter.
Another difference is the trading unit. Stocks are normally traded in round lots, and a round lot for most stocks is 100 shares.
Similarly, a standard option contract is a contract to buy or sell 100 shares of the underlying asset. Futures contracts aren’t so neat and tidy. For example, one corn contract is for 5,000 bushels, while one sugar contract is for 112,000 pounds; a gold futures contract is for 100 troy ounces, and the standard futures contract on the S&P 500 Index is equal to $250 times the quoted value. Therefore, when you enter a futures contract to buy corn, you are legally bound to buy 5,000 bushels at the specified price on the contract unless you reverse out of your position prior to delivery, and if you enter a futures contract to sell sugar, you are legally bound to deliver 112,000 pounds of it when the date arrives.
The investor who is agreeing to buy the underlying asset at a future time is said to be taking a long position in the contract, while the investor agreeing to sell the underlying asset is taking a short position. Upon entering a position, both the long and the short positions must put up a good faith deposit referred to as a “margin.” This is all the cash that is required by either side initially. Don’t confuse it with the initial margin requirement on a stock market margin transaction; there is no similarity. The margin on a futures contract is used in the daily adjustment of the long and short accounts. This practice is called “marking to market,” and there is no such procedure in either the stock or options markets.
To illustrate, assume the price of a futures contract on corn for delivery two months from now is $3 a bushel, and the margin requirement is 10%. Both the long and the short positions will have to put up $1,500 when they enter this contract. (Recall from above that a corn contract is for 5,000 bushels, so the value of the contract is $3 x 5,000 = $15,000, and 10% of this is $1,500.) The price of the contract at the end of the day is called the settlement price, or, more simply, the “settle.” Each day the contract is “marked to market” at this settlement price, which means that if you are long in the contract, you will have to pay this new price when you take delivery, and if you are short in the contract, this is the price you will receive when you deliver the corn.
So, how have you locked in the price at which you will be buying or selling the corn by entering this futures contract? Each day, if the settlement price is higher than it was the day before, the difference is deducted from the margin accounts of the short positions and deposited in the accounts of the long positions. If the settlement price is lower than it was the day before, the difference is deducted from the margin accounts of the long positions and added to that of the long positions. So, if the price of corn has had a net increase of, say, $0.50 a bushel from the time you entered the contract to the time of delivery and you were long in corn, you will now have to pay $3.50 a bushel when you take delivery, but your account will have been increased by $0.50 a bushel with the daily marking-to-market, so you will effectively be paying a net of $3 a bushel for the corn.
Similarly, if you were short in this corn futures contract, you will receive $3.50 a bushel when you deliver the corn, but $0.50 will have been deducted from your account in the daily marking-to-market, making your net $3 a bushel, which is the price at which you agreed to sell the corn when you entered the contract.
Only hedgers will remain in a contract until delivery: the corn farmer who has corn to sell or the cornmeal factory that uses the corn in its end product, for example. Individual investors without a position in the underlying asset use futures contracts to place bets, reversing out of their positions at some point prior to delivery.
To continue with the corn example, let’s assume the Midwest has been plagued with a drought during the current growing season, and you expect this to drive the price of corn above what you observe the futures price on corn for delivery two months hence is. Since short positions must pay long positions when the settlement price increases, you could enter a long position in the corn futures contract in hopes of making a profit if you’re right.
Again, let’s assume that you enter the contract at $3 a bushel. If corn for delivery in two months settles at $3.05 the next day, you will have made a nickel a bushel, or $250, profit on the transaction in just one day. If, instead, corn decreases to $2.95 a bushel, you will have lost $250 on the transaction. In either case, you can take your profit or accept your loss immediately by reversing out of the contract. You accomplish this by taking the opposite position in it. In this example, you were “long” in corn, so you would reverse out by entering a short position in the exact same contract. Or, you can let it ride. Just be certain to reverse out before delivery, or you will have to figure out what to do with your 5,000 bushels of corn.