What you will learn
- Define a forward and a futures contract
- Explain how futures reduce counterparty risk through clearing and daily settlement
- Compute the payoff of a futures position
- Understand why the payoff is linear and symmetric
The simplest derivatives are forwards and futures: agreements made today to transact at a set price on a future date. They are closely related, and they form the foundation for the more complex options that follow. Both share one feature that sets them sharply apart from options: they obligate both parties to act, no matter where the price ends up.
What are futures? (The Plain Bagel)
A grounded explanation of futures contracts and how they are used. Focus on the obligation to transact.
The forward contract
A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. The price is locked in today, but the exchange happens later. Forwards are private, customized agreements traded over-the-counter, which makes them flexible but exposes each side to counterparty risk, the danger that the other party fails to honor the deal. A forward is typically settled once, at maturity.
The futures contract
A futures contract is essentially a standardized forward that trades on an exchange. Its terms, the quantity, quality, and delivery date, are fixed by the exchange, which makes it easily tradable. Crucially, futures are cleared through a clearinghouse that stands between the two parties and guarantees the contract, largely removing the counterparty risk that forwards carry. Futures also require margin, a deposit covered later in this unit, and are marked to market daily.
Key terms
- Forward
- A private, customized agreement to trade an asset at a set price on a future date, settled at maturity.
- Futures
- A standardized, exchange-traded, cleared forward that is marked to market daily.
- Long position
- The party agreeing to buy, who gains when the price rises.
- Marking to market
- Settling gains and losses in cash each day as the price moves, rather than waiting until maturity.
Marking to market
The daily marking to market of futures is an important mechanism. Each day, the gains and losses on a futures position are settled in cash, flowing between the two accounts as the price moves. Rather than waiting until maturity to settle up, the contract is effectively reset every day. This daily settlement is what lets the clearinghouse manage default risk, since losses are collected as they occur instead of piling up into a large unpaid obligation.
A forward is a private handshake to trade later. A future is the same promise standardized, cleared, and settled a little every day.
Futures contracts explained: a complete beginner's guide (Ryan O'Connell)
Walks through the mechanics, including margin and settlement. Reinforces the linear payoff.
The linear, symmetric payoff
Both forwards and futures have a payoff that is linear and symmetric, an important contrast with options. The long party (agreeing to buy) gains when the price rises above the agreed level and loses when it falls below, dollar for dollar. The short party (agreeing to sell) has the mirror-image outcome. Because both are obligated to transact regardless of where the price ends up, gains and losses move one-for-one with the underlying, with no asymmetry between upside and downside.
- final price = price of the underlying at settlement
- agreed price = the locked-in futures price
- contract size = units per contract
The payoff of a long futures position
You go long a futures contract agreeing to buy at 100 dollars, for a contract size of 100 units. At settlement the price is 110 dollars. What is your profit?
- Find the price move. Final 110 minus agreed 100 is 10 dollars per unit.
- Multiply by contract size. 10 dollars times 100 units.
- Read the result. A profit of 1,000 dollars.
Why it matters: The long gains dollar for dollar as the price rises. The short who sold to you loses exactly 1,000 dollars, since every futures contract is a zero-sum mirror between the two sides.
Compute a futures P&L
You go long a futures contract to buy at 50 dollars, contract size 200 units. At settlement the price is 44 dollars. What is your profit or loss, in dollars? (A loss is negative.)
What they are used for
Forwards and futures are the workhorses of hedging and speculation. A farmer can sell futures to lock in a crop price months before harvest, protecting against a decline, while an airline can buy futures to fix the cost of fuel, protecting against a rise. These are textbook hedges, transferring price risk to someone willing to bear it. Speculators, meanwhile, use futures to bet on price direction with leverage. Futures exist on a vast range of underlyings, including commodities, stock indices, currencies, and interest rates, making them one of the most widely used derivatives.
Lock in the price
A wheat farmer will harvest in six months and fears the price of wheat will fall by then. Which futures position locks in today's price and protects them?
The farmer will sell wheat, so they are hurt by a falling price. Going short wheat futures locks in today's price: if wheat falls, the gain on the short futures offsets the lower crop price. This is a classic producer hedge.Right versus obligation
In your own words, explain why the payoff of a futures contract is symmetric, and how that differs from what you expect from an option.
Write an answer before comparing it with the model response.
Model answer
A futures contract obligates both parties to transact at the agreed price no matter where the underlying ends up, so the long gains exactly what the short loses and vice versa, dollar for dollar. There is no way to walk away from a bad outcome, which is why the gains and losses are linear and symmetric around the agreed price. An option is different because it grants a right without an obligation: the holder can exercise when it pays off and simply let it expire when it does not. That ability to avoid the bad side gives options an asymmetric payoff, unlike the two-sided, symmetric payoff of a future.
Forwards and futures obligate both sides, giving a symmetric payoff. Options break that symmetry by granting a right without an obligation, which is where the real versatility begins. The next lesson introduces them.