Futures Contracts

From American farmers in 1865 to hedge funds at 3am — how they work

9 min read Intermediate

"Futures were invented so that a wheat farmer in 1865 could lock in a selling price before harvest. Today the same contract structure is used by oil companies, central banks, and algorithmic traders — all for exactly the same reason: certainty."

For educational purposes only. Nothing in this chapter is financial advice. All figures are illustrative examples. Tax rules, account types, contribution limits, and regulations differ by country and change over time. Always verify current rules with official government sources or a qualified financial adviser before making any investment decisions.

What a Futures Contract Is

A futures contract is an agreement to buy or sell a specific quantity of an asset at a predetermined price on a specific future date. Unlike options, both parties are obligated to fulfil the contract — there is no choice involved.

Futures are exchange-traded and standardised: the quantity, quality (for commodities), delivery location, and expiry date are all fixed. This standardisation makes them liquid and transparent.

Example: oil futures

An airline needs 100,000 barrels of jet fuel in December. Oil is currently $85/barrel. The airline sells capacity in December at today's ticket prices, assuming $85 oil. If oil rises to $110, they lose $2.5 million on fuel costs relative to their pricing. To hedge this, they buy December oil futures at $85. If oil rises, their futures position gains, offsetting the higher fuel cost. They have locked in $85 regardless of what the spot price does.

How Futures Work Mechanically

Initial margin

A deposit (typically 3–12% of contract value) required to open a futures position. This is leverage — you control a much larger position than you deposit.

Mark to market

Futures are settled daily. Profits and losses are added or deducted from your margin account every trading day, not just at expiry.

Maintenance margin

If losses reduce your margin below a threshold, you receive a margin call — you must deposit more funds or your position is closed.

Rollover

Futures expire. Active traders "roll" positions forward by closing the expiring contract and opening the next one, continuously.

Contango / backwardation

When future prices are above spot (contango) or below spot (backwardation). Matters for commodity ETF investors who hold futures-based products.

Futures for Retail Investors

Most retail investors access futures indirectly — through ETFs that hold futures contracts on commodities (oil, gold, agricultural goods). These products carry contango drag, which erodes returns over time in normal market conditions.

Direct futures trading is available to retail investors through futures brokers, but the leverage involved makes it high-risk. A 1% move on an S&P 500 futures contract (E-mini) represents roughly $2,000 profit or loss — on a margin deposit that may be $12,000.

FAQs

What happens if I hold a commodity futures contract to expiry?

You are obligated to take delivery of the underlying commodity. In practice, retail traders always close or roll before expiry. This is why the "oil went negative" story in April 2020 happened — traders caught holding expiring contracts they could not deliver.

What is the E-mini S&P 500 futures contract?

A popular index futures contract representing $50 × the S&P 500 index level. At 5,000 points, one contract = $250,000 notional. Micro contracts ($5 ×) are available for smaller accounts.

Are futures taxed differently from shares?

In the UK, financial futures profits are generally subject to CGT. Futures-based spread bets are tax-free. In the US, futures have a special 60/40 rule: 60% taxed at long-term rates, 40% at short-term, regardless of holding period.

What markets have futures?

Stock indices (S&P 500, FTSE 100, DAX), commodities (oil, gold, wheat, copper), currencies (GBP/USD, EUR/USD), interest rates, and crypto (BTC, ETH futures on CME).

Key takeaways

Futures are binding contracts to buy/sell an asset at a set price on a set date — both parties must fulfil.
They are standardised, exchange-traded, and settled daily (mark to market).
Leverage is built in — a small deposit controls a large notional position. Margin calls are real.
Most retail investors access futures indirectly through commodity ETFs — which carry contango drag.
Always close futures before expiry unless you actually want to receive barrels of oil.