A futures contract is a binding agreement to buy or sell a specific asset at a set price on a set date in the future. Unlike options, which give you the right but not the obligation to trade, futures require both the buyer and the seller to follow through, unless one side closes the position before the contract expires. Futures trade on exchanges for commodities like oil, gold, and wheat, as well as financial instruments like stock indexes, interest rates, and currencies.
The Basic Structure of a Futures Contract
Every futures contract spells out four things: the asset being traded, the quantity, the price, and the expiration date. These details are standardized by the exchange, so all participants trade the same product. You don’t negotiate terms with a counterparty the way you might in a private deal.
When you buy a futures contract, you’re agreeing to purchase the underlying asset at the stated price when the contract expires. When you sell one, you’re agreeing to deliver it. In practice, most traders never take delivery of barrels of oil or bushels of corn. They close their positions before expiration by entering an offsetting trade, essentially canceling their obligation. Only a small fraction of futures contracts result in physical delivery.
Each contract has a multiplier that determines how much a one-point price move is worth in real dollars. The E-mini S&P 500 futures contract, one of the most actively traded in the world, has a multiplier of $50. If the S&P 500 index moves one full point, each contract gains or loses $50. A 20-point move means $1,000 per contract. That multiplier is what connects abstract index points to actual money in your account.
How Margin Creates Leverage
You don’t pay the full value of a futures contract upfront. Instead, you deposit a fraction of the contract’s total value, called initial margin. This typically ranges from 2% to 12% of the contract’s notional value, depending on the product. If you’re trading a contract worth $100,000, you might only need to put up $5,000 to $12,000.
This is what makes futures a leveraged instrument. A relatively small amount of capital controls a much larger position, which amplifies both gains and losses. If the contract’s notional value is $100,000 and your margin deposit is $5,000, a 5% move in your favor doubles your money. A 5% move against you wipes out your entire deposit.
Once you hold a position, you’re subject to the maintenance margin requirement, which is the minimum balance your account must hold. If losses push your account below that threshold, your broker issues a margin call, requiring you to deposit enough cash to bring your account back to the initial margin level. You typically have one business day to meet a margin call. If you don’t, the broker can liquidate your position at whatever the current market price happens to be, and you’re responsible for any resulting losses.
Daily Settlement and Mark to Market
Futures don’t wait until expiration to settle up. Every trading day, the exchange sets an official settlement price for each contract, and the clearinghouse recalculates every open position against that price. This process is called mark to market.
The math is straightforward. Your daily profit or loss equals the difference between today’s settlement price and yesterday’s, multiplied by the contract multiplier and the number of contracts you hold. If you’re long (you bought) and the settlement price rose by 10 points on a contract with a $50 multiplier, $500 per contract is credited to your account. If the price fell by 10 points, $500 per contract is debited.
These daily cash transfers, called variation margin, flow from losing accounts to winning accounts through the clearinghouse. Your broker passes the adjustment through to you in real time. This daily settlement process reduces the risk that one side of a trade builds up a massive unpaid loss over weeks or months. It also means your account balance changes every single day you hold a position, not just when you close the trade.
Who Uses Futures and Why
Futures serve two broad purposes: hedging and speculation.
Hedgers use futures to lock in prices and reduce risk in their core business. An airline might buy crude oil futures to protect against rising fuel costs. A wheat farmer might sell futures before harvest to guarantee a price, ensuring they can cover expenses regardless of what happens to crop prices by fall. In both cases, the futures contract acts as insurance. The hedger might miss out on a favorable price move, but they’ve eliminated the uncertainty that could threaten their operations.
Speculators, on the other hand, have no interest in the underlying commodity or index. They’re trading purely to profit from price movements. Because of the leverage built into futures (controlling a large position with a small margin deposit), speculators can generate significant returns on relatively small capital. They also face the risk of losses that exceed their initial investment. Speculators provide liquidity to the market, making it easier for hedgers to find someone on the other side of their trade.
Closing a Position
You have two ways to exit a futures trade. The most common is an offsetting trade: if you bought a contract, you sell an identical one before expiration, and your obligation is canceled. Your profit or loss is the net of all the daily settlements that accumulated while you held the position.
The second way is to hold through expiration. For physically delivered contracts (like certain agricultural or energy products), this means actually taking or making delivery of the commodity. For cash-settled contracts (like most stock index futures), the exchange simply credits or debits the final price difference. No physical asset changes hands. Most individual traders close well before expiration to avoid the logistics and costs of delivery.
How Futures Are Taxed
Regulated futures contracts receive a specific tax treatment under Section 1256 of the tax code, and it works differently from stocks. All open positions are treated as if they were sold on the last business day of the year, even if you haven’t closed them. This is another form of mark to market, but for tax purposes.
Gains and losses on these contracts are split 60/40: 60% is taxed at the long-term capital gains rate and 40% at the short-term rate, regardless of how long you actually held the position. If you opened and closed a trade in three days, 60% of your profit still qualifies for the lower long-term rate. You report these gains and losses on IRS Form 6781. For traders in higher tax brackets, this blended rate can be a meaningful advantage over the ordinary income rate that applies to short-term stock trades.
Key Risks to Understand
Leverage is the defining risk. Because you control a large position with a small deposit, losses can exceed your initial margin quickly. In a fast-moving market, your account can go negative before you have time to react, and you owe the difference.
Liquidity varies by contract. Major products like E-mini S&P 500 futures or crude oil futures trade with tight bid-ask spreads and deep order books. Less popular contracts can have wider spreads and fewer participants, making it harder to enter or exit at the price you want.
The obligation to perform is absolute. Unlike an options contract, where the most you can lose is the premium you paid, a futures contract carries unlimited downside for a buyer if prices crash and unlimited downside for a seller if prices spike. Daily settlement limits the credit risk between parties, but it doesn’t cap how much you can lose over time.