The mechanics of a futures contract involve an agreement for the purchase or sale of an asset at a future date.
For example, an oil producer has plans to produce a million barrels of oil over the coming year, which will be ready for delivery in 12 months. The producer could enter into a contract now, to sell the oil at the current market price in a year’s time, after the oil has all been produced.
Oil prices are extremely volatile so the current price – say, $75 per barrel – could have changed over the next year. So if the producer thinks that prices are unlikely to go up, the contract will lock in that as a guaranteed sales price. On the other hand, if they think the oil price will rise, the contract may not lock in a price now.
Predicting where the price will be in a year’s time uses a mathematical model. This takes into account factors such as the current price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields.
Futures use standardized contracts; for example the oil contract used on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. So to lock in the price for 100,000 barrels would take 100 contracts, and for a million barrels it would be 1,000 contracts – either buying or selling.
Futures markets are regulated by the Commodity Futures Trading Commission (CFTC), a federal agency created by Congress in 1974 to ensure the integrity of futures market pricing. This includes preventing fraud, stopping abusive trading practices, and regulating brokerage firms engaged in futures trading.