Futures Fundamentals: How The Market Works

The futures market is a centralized marketplace for buyers and sellers from around the world who meet and enter into futures contracts. While trading traditionally took place using an open outcry system in exchange trading pits, most exchanges now use electronic trading systems, which reduce costs and improve trade execution speeds.

Each futures contract is specific to the underlying commodity or financial instrument and the date of delivery, and prices for each contract fluctuate throughout the trading session in response to economic events and market activity. Nearly all futures contracts are cash settled and end without the actual physical delivery of the commodity. (For more, see Electronic Trading Tutorial.)

What Exactly Is a Futures Contract? 

Assume that you decide to subscribe to cable TV. As the buyer, you enter into an agreement with the cable company to receive a certain number of cable channels at a set price every month for the next year. This contract made with the cable company is like a futures contract, in that you have agreed to receive a product at a future date, with the price and terms for delivery already set. You have secured your price for the next 12 months – even if the price of cable rises during that time. By entering into this agreement with the cable company, you have reduced your risk of having to pay a higher price.

That's how the futures market works – except instead of a cable TV provider and a consumer, it may be a wheat producer trying to secure a selling price for next season's crop, and a bread maker trying to pin down a buying price to determine how much bread they can make – and at what profit. The farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of wheat to the buyer in May at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price they both believe will be a fair price in May. It’s this contract – and not the wheat – that can then be bought and sold in the futures market. 

An important concept is that a futures contract is an agreement between two parties: one who holds a short position – the party who agrees to deliver a commodity; and one who holds a long position – the party who agrees to receive a commodity. In the above scenario, the farmer would hold the short position because they agreed to sell their wheat, and the bread maker would hold the long position, since they agreed to buy the wheat. Even when no commodity is involved – a stock index future contract, for example – buyers and sellers are still matched together: There’s always another investor on the other side of your trade.

This is a largely anonymous process: Electronic exchanges match buyers and sellers from around the world in real-time throughout each trading session. And keep in mind: Most futures contracts are settled in cash before the contract expires, with no physical delivery taking place.

Profit and Loss – Cash Settlement 

If you trade futures contracts, your profit and loss depends on the daily price movements of the market for that contract. For example, say the futures contracts for wheat increases to $5 per bushel the day after the above farmer and bread maker enter into their futures contract at $4 per bushel. The farmer, as the holder of the short position, has lost $1 per bushel because the selling price just increased from the price at which he is obligated to sell his wheat. The bread maker, as the long position, has profited by $1 per bushel because the price he is obligated to pay is less than what the rest of the market is obliged to pay in the future for wheat. (For related reading, see Profit/Loss Calculations for Speculative Trades.)

On the day the price change occurs, the farmer's account is debited $5,000 ($1 per bushel X 5,000 bushels) and the bread maker's account is credited by $5,000 ($1 per bushel X 5,000 bushels). As the market moves every day, these kinds of adjustments are made accordingly. Unlike the stock market, futures positions are settled on a daily basis, which means that gains and losses from the day's trading are deducted or credited to your account each day at the end of the trading session. In the stock market, the gains or losses from movements in price aren't realized until you sell the stock or cover your short position. 

Most transactions in the futures market are settled in cash – the actual physical commodity is typically bought or sold in the cash market. Prices in the cash and futures market tend to move parallel to one another, and when a futures contract expires, the prices merge into one price. When either party decides to close out their futures position, the contract will be settled. If the contract was settled at $5 per bushel, the farmer would lose $5,000 on the futures contract and the bread maker would have made $5,000 on the contract. 

After the settlement of the futures contract, the bread maker still needs wheat to make bread, so he will in buy wheat in the cash market (or from a wheat pool) for $5 per bushel (a total of $25,000) because that's the price of wheat in the cash market when he closes out his contract. However, technically, the bread maker's futures contract profits of $5,000 go towards his purchase, which means he still pays his locked-in price of $4 per bushel ($25,000 - $5,000 = $20,000). The farmer, after also closing out the contract, can sell his wheat on the cash market at $5 per bushel, but because of his losses from the futures contract with the bread maker, the farmer still actually receives only $4 per bushel. In other words, the farmer's loss in the futures contract is offset by the higher selling price in the cash market – something referred to as hedging. (For more, see Hedging Basics: What is a Hedge?)

A futures contract is really more like a financial position, and the two parties in the wheat futures contract discussed above could be two speculators rather than a farmer and a bread maker. In such a case, the short speculator would simply have lost $5,000, while the long speculator would have gained that amount. In other words, neither would have to go to the cash market to buy or sell the commodity after the contract expires; they would simply settle in cash.   

Economic Importance of the Futures Market 

Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today and tomorrow's estimated supply and demand. Futures market prices depend on a continuous flow of information from around the world, and require a high level of transparency. Factors such as weather, political instability, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity.

Futures markets are also a place for people to limit risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This ultimately helps reduce the cost to the retail buyer because with less risk there is less of a chance that producers will raise prices to make up for any financial losses in the cash market.