What is Futures Contract? (Plain English Definition)
Definition: A futures contract is a standardized agreement to buy or sell an asset at a predetermined price on a specific future date.
Futures Contract Explained Simply
A futures contract is a binding agreement between two parties to buy or sell an asset at a specific price on a specific future date. Futures exist for many types of assets including stock indices, commodities like oil and gold, currencies, interest rates, and even cryptocurrency. They are traded on regulated exchanges like the Chicago Mercantile Exchange (CME).
Futures are used by different market participants for different purposes. Farmers use commodity futures to lock in prices for their crops. Airlines use oil futures to hedge fuel costs. Speculators use futures to bet on price movements with leverage. ETF providers use futures to construct certain types of funds, especially commodity ETFs and leveraged or inverse ETFs.
A key feature of futures is that they involve leverage. You only need to put up a fraction of the contract's value (called margin) to control the full position. This means futures can produce large gains or losses relative to the initial investment. For ETFs that use futures, this introduces additional considerations like roll costs when the fund must replace expiring contracts with new ones.
Futures Contract Example
A commodity ETF that tracks oil prices does not buy and store physical barrels of oil. Instead, it buys crude oil futures contracts. If the current futures price is $75 per barrel, the ETF might hold 1,000 contracts representing 1 million barrels of oil exposure worth $75 million. As the futures price moves to $80, the ETF gains $5 million. Before the contracts expire, the ETF sells them and buys new contracts for a later date -- this process is called rolling.
Why Futures Contract Matters for ETF Investors
Understanding futures is important for ETF investors because many popular ETFs use them. Commodity ETFs, volatility ETFs, and leveraged/inverse ETFs all rely on futures contracts. The performance of these futures-based ETFs can differ significantly from the underlying asset due to roll costs and contango effects. For ETF investors considering commodity or leveraged products, knowing that they use futures helps you understand why these funds may not track their target asset perfectly over longer periods. A commodity ETF might underperform the actual commodity price by 5-10% per year due to the costs of rolling futures contracts. This makes futures-based ETFs generally better suited for short-term tactical trades than long-term buy-and-hold positions.
Futures Contract vs Derivative
| Futures Contract | Derivative |
|---|---|
| A futures contract is a standardized agreement to buy or sell an asset at a predetermined price on a specific future date. | See full definition of Derivative |
While futures contract and derivative are related concepts, they serve different purposes in the world of ETF investing. Understanding both terms helps you make more informed decisions about which funds to include in your portfolio and how to evaluate their performance.
Related Terms
Deepen your understanding of ETF investing by exploring these related concepts:
Derivative
A derivative is a financial contract whose value is based on the performance of an underlying asset, such as a stock, bond, or index.
Options
Options are contracts that give the holder the right, but not the obligation, to buy or sell a security at a specified price before a specified date.
Leveraged ETF
A leveraged ETF uses derivatives and debt to multiply the daily return of an underlying index, typically by 2x or 3x.
Inverse ETF
An inverse ETF is designed to deliver the opposite return of its benchmark index on a daily basis, rising when the market falls and falling when it rises.
Hedge
A hedge is an investment made to reduce the risk of adverse price movements in another investment, acting as a form of financial insurance.
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