What Does a Contract Mean in Futures Trading?

In futures trading, a contract is an agreement that lets traders, investors, and commodity producers speculate on the future price of an asset. It is an agreement between two parties to trade a product at a price set when the contract is made, on a future date (the expiration date).

• The underlying asset of a futures contract can come from any asset class, including stocks, commodities, currencies, interest rates, and bonds.
• Traditional futures contracts are legally protected and trade only on specific exchanges.
• In most cases, a clearing house guarantees the execution of futures contracts. As a result, traders can trade with reduced counterparty risk.

The Origins of Futures Contracts

The first futures markets were created in 17th-century Europe. However, Japan's Dojima Rice Exchange in the early 18th century is considered the first futures exchange. At the time, most payments in Japan were made in rice. Futures contracts began to be used as a way to hedge against the risk of volatile rice prices. Later, with the arrival of electronic trading systems, futures contracts grew in popularity, and today they are widespread across the entire financial industry.

3 Roles of Futures Contracts

In finance, futures contracts generally serve the following 3 functions.

• Hedging and risk management: Futures contracts can be used to mitigate specific risks. For example, a farmer can sell futures contracts on their produce to lock in a certain price in the future, regardless of adverse events and market swings.
• Leverage: Futures contracts allow investors to open leveraged positions. Because the contract is settled on the expiration date, investors can leverage their positions. For example, with 3:1 leverage, a trader can take a position three times larger than their trading account balance.
• Short exposure: Futures contracts allow investors to go short on an asset. When an investor sells a futures contract without owning the underlying asset, it is commonly called a "naked position."
• Speculating on a variety of assets: Futures contracts let investors gain exposure to assets that are hard to trade on the spot market. For example, commodities like crude oil are usually expensive to ship and costly to store, but with futures contracts, investors and traders can speculate on crude oil.
• Price discovery: Futures markets are a trading venue for sellers and buyers (that is, where supply and demand meet) for many asset classes, such as commodities. For example, oil prices can be determined in relation to real-time demand in the futures market rather than by the prices traded at gas stations.

Understanding Settlement Mechanisms

The expiration date of a futures contract is the last day of trading activity for that particular contract. After that, trading stops and the contract is settled. There are two main mechanisms for settling futures contracts.

• Physical settlement: The underlying asset is exchanged between the two parties to the contract at a predetermined price. The party holding the short (sell) position is obligated to deliver the asset to the party holding the long (buy) position.
• Cash settlement: The underlying asset is not exchanged directly. Instead, one party pays the other an amount reflecting the asset's current value. A typical example of a cash-settled futures contract is the crude oil futures contract: since physically trading thousands of barrels is quite complicated, cash is exchanged instead of barrels of crude oil.

Cash-settled futures contracts are often more convenient than physically settled ones. For this reason, cash settlement is used more often even for liquid financial securities or fixed-income products, where ownership can be transferred fairly quickly.

However, cash-settled futures contracts can lead to manipulation of the underlying asset's price. This type of market manipulation is commonly called "banging the close," a term describing abnormal trading activity that deliberately disrupts the order book as a futures contract nears its expiration date.

3 Strategies and Ways to Close a Futures Contract

After entering a futures contract position, a futures trader has three main strategies available.

• Closing a position (offsetting): This means closing a futures contract position by creating an opposite position of equal value. For example, a trader who sold 50 futures contracts can hedge the initial position by opening a long position of the same size. This strategy lets traders realize profits or losses before the settlement date.
• Rollover: This happens when a trader offsets the initial position and then decides to open a new futures contract position, which essentially extends the expiration date. For example, if a trader who bought 30 futures contracts expiring in the first week of March wants to extend the position for six months, they can close the initial position and open a new position of the same size with an expiration date set for the first week of October.
• Settlement: If a futures trader neither offsets nor rolls over the position, the contract is settled on the expiration date. At this point, the parties involved are legally obligated to exchange the asset (or cash) according to their positions.

Futures Contract Price Patterns: Contango and Normal Backwardation

From the moment a futures contract is created until it is settled, the contract's market price keeps changing in response to buying and selling forces.

The relationship between a futures contract's maturity and its price changes creates various price patterns. These are commonly called contango (1) and normal backwardation (3). As shown in the figure below, these price patterns are directly linked to the asset's expected spot price (2) on the expiration date (4).

• Contango (1): A market condition in which the futures contract price is higher than the expected future spot price.
• Expected spot price (2): The asset price expected at the time of settlement (the expiration date). The expected spot price is not fixed and changes with market supply and demand.
• Backwardation (3): A market condition in which the futures contract price is lower than the expected future spot price.
• Expiration date (4): The last day of trading activity for a particular futures contract, before settlement takes place.

Contango market conditions tend to favor sellers (short positions) over buyers (long positions), while normal backwardation markets generally favor buyers.

As the expiration date approaches, the futures contract price is expected to gradually converge with the spot price until they eventually have the same value. If the futures contract and spot prices are not equal on the expiration date, traders can make quick profits through arbitrage opportunities.

In a contango scenario, futures contracts usually trade above the expected spot price. For example, a futures trader may decide to pay a premium for a physical commodity to be delivered at a future date so they don't have to worry about paying costs such as storage and insurance (gold is a typical example). Companies can also use futures contracts to lock in future costs at a predictable value and buy raw materials essential to their business (for example, a bread maker buying wheat futures contracts).

On the other hand, a backwardation market occurs when futures contracts trade below the expected spot price. Traders can buy futures contracts expecting to profit if the price rises as anticipated. For example, if a futures trader can buy a contract for barrels of crude oil at $30 today and the spot price next year is expected to be $45, they may enter a long position.

Wrapping Up

Futures contracts are a standardized type of forward contract and one of the most widely used instruments in the financial industry. They offer a range of functions and can be used in many ways. However, before investing your money, it is important to understand the basic mechanics of futures contracts and the specific market well.

Locking in an asset's price for the future can be useful in certain situations, but it can be quite risky, especially with contracts that use margin and leverage. That's why a proper risk management strategy is needed to reduce the unavoidable risks of trading futures contracts. Some traders also use technical analysis indicators together with fundamental analysis methods to gain insight into price movements in the futures market.