Futures Contracts

A futures contract is a type of derivative agreement to buy or sell a specific commodity or financial instrument at a predetermined price on a future date. Think of it as a legally binding handshake to trade something later, but with the price locked in today. Unlike simply agreeing with a friend to buy their old car next month, futures are highly standardized and traded on a futures exchange. This standardization—covering everything from the quantity and quality of the underlying asset (like 1,000 barrels of West Texas Intermediate crude oil) to the delivery date—is what allows them to be traded quickly and efficiently by people all over the world. The primary purpose of these contracts is to allow producers and consumers to manage price risk, but they also attract speculators betting on where prices will go next.

At its core, a futures contract involves two parties with opposite views on the future price of an asset. The buyer of the contract takes a long position, agreeing to buy the asset at the set price, and will profit if the asset's market price rises above the contract price. The seller takes a short position, agreeing to sell the asset, and will profit if the market price falls below the contract price.

Every futures contract has standardized terms set by the exchange it trades on. This ensures that every contract for, say, December Corn, is identical, making them interchangeable or 'fungible'. The key components are:

• The Underlying Asset: What is being traded (e.g., corn, gold, oil, or a stock index like the S&P 500).
• The Contract Size: The specific quantity of the asset (e.g., 5,000 bushels of corn).
• The Delivery Month: When the transaction is set to occur (e.g., March, May, July).
• The Price: The agreed-upon price per unit of the asset.

Most traders don't actually wait for the delivery date. Instead, they close their position by taking an offsetting trade—a buyer sells an identical contract, or a seller buys one—before the contract expires, simply settling the profit or loss in cash.

Futures are not traded directly between two people but through a centralized exchange, like the CME Group. This ecosystem is protected by a clearing house, which acts as the middleman for every transaction. It becomes the buyer to every seller and the seller to every buyer. This clever setup virtually eliminates counterparty risk—the danger that the person on the other side of your trade will fail to pay up. To participate, traders must post a good-faith deposit known as margin. If a trade moves against them, they may get a “margin call,” requiring them to add more funds to cover potential losses, ensuring the system remains stable.

Traders come to the futures market with two primary motivations: to hedge against risk or to speculate for profit.

Hedging is the original and arguably most important function of the futures market. It's a strategy to reduce the risk of price volatility.

• Example for a Producer: An Iowa corn farmer expects to harvest 50,000 bushels in six months. She's worried that by the time she's ready to sell, the price of corn will have dropped. She can sell futures contracts today, locking in a profitable price. If the market price does fall, her loss in the cash market is offset by her gain on the futures contracts.
• Example for a Consumer: A large bakery that uses tons of wheat is worried that prices will rise, increasing its costs. It can buy wheat futures contracts, locking in a purchase price. If the market price does rise, the extra cost of buying physical wheat is offset by the profit made on its futures position.

In both cases, the goal isn't to make a killing, but to achieve price certainty and run a more predictable business.

Speculators have no interest in producing or consuming the underlying asset. They are simply betting on the direction of prices. Because futures require only a small margin deposit to control a large amount of the underlying asset, they offer enormous leverage. A small price movement can lead to massive gains or, more frequently for the inexperienced, devastating losses. While often seen as pure gamblers, speculators are essential to the market. They take on the risk that hedgers want to offload and provide the liquidity (the ease of buying and selling) that makes the market work smoothly for everyone.

For a dedicated value investing practitioner, the world of futures is largely a sideshow—and a dangerous one at that. The philosophy of buying wonderful businesses at fair prices and holding them for the long term is fundamentally opposed to the short-term, price-focused nature of futures trading. Warren Buffett famously called derivatives “financial weapons of mass destruction,” highlighting the immense risks they pose, especially when combined with leverage. The average investor's time is far better spent analyzing a company's balance sheet, competitive advantages, and management quality than trying to predict next month's price of oil or soybeans. While understanding futures market trends can offer clues about industry costs (e.g., what high jet fuel futures mean for airlines), actively trading them is a specialized game best left to professionals and sophisticated speculators. For value investors, the real fortune is found in owning a piece of a great business, not in a contract that expires next quarter.