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What is a futures contract?

Futures contracts defined

It’s a deal you agree with someone to buy or sell something in the future (the clue’s in the name) at a price agreed today. That 'something' can be anything – a share, a commodity, a currency – and delivery can be months away, if ever. The point is that the price is agreed here and now.

Where have you heard about futures contracts?

You’ve probably come across them in news reports about markets for things like oil, wheat or metals. That’s because the prices agreed in futures contracts are seen as important indicators of wider trends. So let’s say the futures price of oil is shooting up, that suggests higher energy costs are on their way.

What you need to know about futures contracts

Millions of us have signed 'futures contracts' without even realising it, the agreement to buy a house (with the price agreed now and final payment at a fixed date in the future) follows exactly the same principle.

One big difference though, is that contracts in the futures markets can be, and are, traded back and forth among market dealers.

Which brings us to a second big difference, while all futures contracts can end up with the holder having to buy or sell at the settled price and complete the deal, most never get to the agreed date. Why not? Because whichever party to the contract is looking likely to win from the deal will cancel it before the settlement date.

How can they do that? By going to the market and buying that contract’s 'opposite', an agreement either to buy or to sell whatever is the asset in question. This has the effect of closing the original contract and taking the profit.

This is in sharp contrast with forward contracts, which are usually intended to run all the way to delivery.

Futures contracts are marked to market at the end of each trading session to give a daily valuation of their position in relation to market values. Since the financial crisis there have been increasing demands that futures deals are cleared through exchange rather than over the counter, to provide more transparency.

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