A futures contract is an obligation to buy or sell an underlying product at a specific price at a specific time in the future.

Investors have many choices today for investing their money. The first one that often comes to mind is the stock market. It has been estimated that more than 50 million U.S. citizens have some stake in the performance of the stock market, either through investments in individual stocks or mutual funds or via participation in 401(k) or other company plans, individual retirement accounts, government pension plans, or some other program that gives Main Street residents a piece of Wall Street action.

Then there are the bank certificates of deposit and numerous types of bonds that have long been familiar investment vehicles—passive instruments that are based on interest rates and don’t require much attention.

So you may be wondering why you should be interested in a more active trading style featuring futures, options on futures, or cash foreign exchange markets, traditionally perceived as more risky places to put your money.

Futures markets have benefits that the stock market simply can’t provide, and traders are just beginning to discover what brilliant tools they are for participating in a wide variety of markets. Long known, used, and understood by producers and users of commodities such as grain, gold, and crude oil, futures markets today also encompass such financial products as stocks, stock indexes, and interest rates. What’s more, futures markets are not just a U.S. phenomenon—they exist the world over, on every continent but Antarctica.

When it gets right down to it, futures aren’t hard to understand. In fact, they are fairly straightforward. Like stocks, “buy low, sell high” is the basic premise. What’s different is that you can trade futures with leverage, and on either a long or a short position. That introduces an additional element of risk not present in the stock market. Another significant difference is that there is no uptick rule in futures. Thus, it is just as easy to sell short as it is to buy, thus easing entry into a position to capture a downward move in prices.

Historical origins

Some people say that the concept of futures trading began in China nearly 1,400 years ago and that it was also used in the Japanese rice market centuries ago. But futures trading as U.S. traders know it today has its roots in the mid-1800s when it all started in Chicago, the city that works.

Mother Nature blessed Chicago with a location that lent itself to becoming a center of commerce—at the south end of Lake Michigan and at the mouth of a river system that reached all the way to the Gulf of Mexico. From Chicago, distributors and suppliers could reach the East Coast via the Great Lakes and the midsection of the country by river. This location in the middle of the United States also helped Chicago become a railroad hub.

This was good news for producers and users of commodities, such as wheat and corn. Farmers brought their harvest to Chicago to sell it to the companies that would turn it into bread and other foodstuffs. Chicago provided one central location for buying and selling. It was a great idea but still needed improvement.

At harvest time, the supply of grain overwhelmed the demand, so prices were low. Months later, prices would rise as supplies dwindled. Farmers wanted a way to cash in on the higher prices. Users wanted a way to ensure steady supplies as well as smooth out and better predict how much their raw ingredients would cost. So they started making deals that established the price of grain for a delivery date in the future.

But there still was the matter of what we call today “counterparty risk.” The Chicago Board of Trade (CBOT), founded in 1848, solved the problem by creating standardized contracts for the future sale of grain. The contracts were interchangeable, so the buyer or seller of a contract could get out of the obligation without any harm to the original counterparty. In the 1920s, the CBOT added a clearinghouse to become the ultimate counterparty to everyone who trades a futures contract. To date, this clearinghouse system has never had a default. Economic necessity gave birth to futures markets. And good old American ingenuity has kept redefining the futures markets ever since.

Futures definition

A futures contract is an obligation to buy or sell an underlying product at a specific price at a specific time in the future. We’ll explain each key phrase in that sentence, so you can understand the elements that define a futures contract.

Obligation to Buy or Sell

The key word is obligation. Unless you offset your original position before the contract expires—and nearly 100 percent of speculators do just that—you must eventually buy or sell at the agreed-upon price when the contract expires. Here is a brief explanation of how buying and offsetting a position might work with an E-mini Standard & Poor’s 500 stock index futures contract. All futures contracts follow this same scenario, differing only in the total contract size and value of the contract.

Long Position Example You buy a June E-mini S&P 500 index futures contract when it is trading at 1000. The contract size is $50 times the index level, so your position equals a $50,000 ($50 × 1000) stake in the S&P 500 index. If the index goes up 10 points before the futures contract expires, you would receive $500, less commission and fees.

If the index declines 10 points to 990, the value of the contract drops to $49,500. Unless you offset your position by selling a June E-mini futures contract before it expires in the third week of June, you will be obligated to pay the difference in contract value of the price at which you bought versus the final expiration price to fulfill your side of the deal. This cash payment occurs because the E-mini S&P 500 is “cash-settled.” In futures contracts that require physical delivery, you would be required to buy the underlying product. (Most futures positions are offset before expiration, however.)

Short Position Example You sell a June E-mini S&P 500 futures contract when it is trading at 1000. Just as when buying to initiate a position, the contract size is $50 times the index level, so your position equals a $50,000 ($50 × 1000) stake in the S&P 500 index. If the index rises 10 points to 1010 when the futures contract expires, the value of the contract increases to $50,500.

Unlike shorting in stocks, the next part in futures trading is just like the long position example. Unless you offset your position by buying a June E-mini contract before it expires, you will be obligated to pay the difference in contract value of the price at which you sold versus the final expiration price to fulfill your side of the deal. Once again, this cash payment occurs because the E-mini S&P 500 is cashsettled. In futures contracts that require physical delivery, the seller is required to supply the underlying product to a buyer to fulfill the contract obligation if the position is not offset. (But you don’t have to worry about that with stock index futures.) If you sell and the index declines by 10 points, you would receive the $500, less commission and fees.

Underlying Product

Futures contracts originally were created for agricultural products such as corn and cotton. In the 1970s and 1980s, futures contracts on financial instruments such as U.S. Treasury bonds and stock indexes became popular. Futures contracts on individual stocks, called “single-stock futures,” are the latest innovation in this financial arena.

Each futures contract specifies a certain amount (and sometimes quality) of the underlying product, so that the contract terms are standardized for all participants. For example, one E-mini S&P 500 futures contract represents exposure to all 500 stocks in the S&P 500 index. Contract standardization means that investors don’t have to worry about anything but the business at hand—changes in price.

Specific Price

Futures contracts are traded in public, government-regulated forums—exchanges where business is conducted either electronically or in traditional open-outcry pits on a trading floor. Prices are determined by the orders that come into the market from buyers and sellers. When an order from a buyer at $100 meets an order from a seller at $100, a trade occurs and a futures price of $100 is broadcast to the world.

Specific Time in the Future

Futures contracts expire at a certain time in the future. For example, a December 2005 futures contract will cease to exist sometime during the month of December in 2005 (depending on rules set by the exchange). Specifically, E-mini S&P 500 futures expire on the morning of the third Friday of March, June, September, and December. As with other elements of the contract, a standardized expiration date makes it easier for investors to focus on pricing decisions.