Futures are: a complete guide to understanding derivative contracts

When you hear the phrase “futures are a type of investment,” many people think it’s a complicated scheme for professionals. In reality, although futures require understanding and caution, the basic idea is simple: it’s an agreement to buy or sell a specific asset in the future at a price you lock in today. Futures are traded on a wide range of markets—from commodities to currencies and cryptocurrencies—and they offer unique opportunities but also carry serious risks, especially for beginners.

The essence of futures contracts: what’s behind the name

Futures are derivative financial instruments based on the idea of anticipated changes in asset prices. Instead of buying the asset directly now, you enter into a contract with an obligation to do so (or sell) in the future at a predetermined price. So, futures are not the assets themselves but promises related to them.

Underlying assets for futures contracts include:

• Commodities: coffee, soybeans, oil, precious metals
• Stock indices: S&P 500, reflecting the performance of major companies’ stocks
• Cryptocurrencies: Bitcoin and other digital assets
• Individual stocks and exchange-traded funds (ETFs)
• Bonds and even interest rates

The main difference between futures and simply owning an asset: futures allow you to manage the risk of future price fluctuations by locking in the value in advance.

Futures market: where supply and demand meet

Futures trading takes place on specialized exchanges where different types of participants come together. Here, standardized contracts are exchanged among a multitude of players—from large corporations to individual traders.

According to the U.S. Commodity Futures Trading Commission (CFTC), most futures market participants are commercial companies and institutional investors who need the commodity for their business or want to hedge their positions. However, the market also includes speculators and independent investors seeking profit from price movements in the contracts.

A critical point: commodity futures and related financial instruments must be traded through regulated exchanges where participants are registered according to regulatory requirements.

Practical application: how futures work in reality

Futures are a way for two parties to achieve mutually beneficial results. Let’s consider a specific example with jet fuel:

Hedging scenario:

• An airline worries that jet fuel prices will spike and blow their budget. They buy a futures contract that guarantees the right to purchase a certain amount of fuel at a fixed price in three months.
• The fuel supplier, on the other hand, fears falling prices. They sell the same contract, ensuring a minimum selling price.
• Specific terms: both parties agree to buy/sell 1 million gallons with delivery in 90 days at $3 per gallon.

In this example, both participants are hedgers—people and organizations using the futures market to manage risks related to the actual commodity.

Speculation scenario: But not everyone on the futures market wants to take delivery of the actual commodity. Many traders come here to profit from price movements in the contracts themselves. If jet fuel prices rise, the value of the contract increases. A speculator who bought this contract can sell it at a higher price, making a profit without ever intending to take delivery of fuel. These participants provide market liquidity, enabling hedgers to enter and exit positions.

Diversity of futures: not just commodities

Traditionally, people think of futures in terms of raw materials—pigs, corn, oil. But the market has expanded significantly. Futures are also tools for trading:

Stock and index futures: Investors can trade futures on individual company stocks or stock indices. For example, to hedge a stock portfolio against a decline, an investor might sell a futures contract on the S&P 500. If the market drops, profits from the short position offset losses in the portfolio.

Cryptocurrency futures: With the rise of digital assets, futures on Bitcoin and other cryptocurrencies have emerged, allowing traders to gain exposure to volatile assets through more structured instruments.

Bond futures: They help manage interest rate risk and are important tools for institutional investors.

How futures contracts work: what you need to know

Futures are standardized contracts, which is key to their functioning. When you trade futures, you don’t need to negotiate every detail—the exchange has already set the terms. A typical futures contract includes:

• Unit of measurement: kilograms, barrels, ounces, or number of contracts
• Delivery method: physical delivery of the commodity or cash settlement
• Volume: exact quantity of the asset or securities
• Contract currency: the currency in which the price is expressed
• Quality criteria: for commodities, specific requirements (e.g., octane rating of gasoline or purity of metal)

A crucial point for beginners: understand what happens at contract expiration. Most casual investors prefer not to wake up one day with a truckload of pigs at their door. For this reason, most futures positions are closed before the expiration date.

Leverage and margin: trader’s dream and nightmare

One of the main reasons people trade futures instead of owning assets directly is the ability to use leverage. Futures are instruments that allow you to control large positions with relatively small amounts of cash.

For example, a commodity broker might allow you to use 10:1 or even 20:1 leverage, much higher than in stock trading. This means a 5% price move can result in a 50% gain or loss on your investment.

Where the risk lies:

Regulators, including the CFTC, actively warn that futures are complex, volatile instruments not suitable for novice investors. Margin and leverage rules in futures trading are much more liberal than in securities trading.

High leverage means high potential profits but also the risk of catastrophic losses. If markets move against you more sharply than expected, you could lose more money than you initially invested.

Getting started: how to begin trading futures

If you’ve decided that futures are an instrument you’re interested in, the process to start is fairly straightforward but requires careful preparation.

Opening an account: The first step is to find a broker that provides access to the futures markets you’re interested in. The broker will ask about your investing experience, income, and capital. These questions are not arbitrary—they help the broker assess what level of risk (in terms of margin and position size) they can allow.

Fee structure: There is no single standard for commissions and fees in futures trading. Each broker offers different services—from extensive research and advice to just quotes and charts. Compare conditions before choosing.

Paper trading first: Many brokers offer demo accounts where you can practice with virtual money. This is an invaluable tool for beginners, helping you understand how futures work, how markets react to events, and how margin and commissions affect your profit or loss. Even experienced investors often use such accounts to test new strategies.

Education before investing: Before putting in real money, spend time learning. Understanding how futures work in theory and practice is an investment in your future success and can help you avoid costly mistakes.

Futures are a powerful financial tool, but they demand respect for the risks involved. With proper education, discipline, and realistic expectations, you can use them as part of a diversified investment strategy.