What is a futures contract?

A futures contract is a deal made today about a trade that happens later. Two sides agree on three things right now: what will change hands, how much of it, and at what price. The actual exchange happens on a date in the future. That is the whole idea, and everything else in this course builds on it.

The farmer and the baker

Picture a wheat farmer in spring. Her crop will not be ready until fall, and she has no idea what wheat will sell for by then. If the price falls, she could lose money on a whole year of work.

Now picture a baker in town. He needs wheat every month to make bread. If the price of wheat jumps, his costs jump with it, and his business suffers.

They have opposite worries. The farmer is afraid the price will fall. The baker is afraid the price will rise. So they make a deal in spring: in the fall, the farmer will sell the baker a set amount of wheat at a price they both agree on today.

Now both of them can plan. The farmer knows what she will get paid. The baker knows what he will pay. Neither one has to guess anymore.

That handshake deal is the seed of a futures contract.

From a handshake to an exchange

A private deal like that has problems. What if the baker goes out of business before fall? What if the farmer wants out of the deal halfway through the summer? With a private agreement, she would have to find the baker and negotiate.

A private, custom deal like this is called a forward contract. A futures contract fixes those problems in two ways.

1. It is standardized. The exchange writes the rules for every contract: how much, what quality, and when it ends. Every contract of the same kind is identical. The only thing left to decide is the price.
2. It trades on an exchange. Because every contract is identical, anyone can buy or sell one to anyone else. If you want out, you simply trade your contract away to another market participant. You do not need to find the person you started with.

This is not a new idea. In the 1800s, Chicago grew into a hub for grain, and the Chicago Board of Trade introduced standardized futures contracts in 1865. The exchange model that started with grain later spread to many other markets, including the stock market indexes you will learn about in this course.

Do you have to take delivery?

No, and this surprises most beginners. Most futures contracts are closed out before the end date. A trader who bought a contract simply sells one back, and the difference in price is their profit or loss. Some contracts do not involve any physical goods at all. They settle in cash instead. The stock index futures you will meet in Lesson 4 work this way. Nobody delivers a truckload of stocks.

Why this matters to you

You are not a farmer or a baker. You will likely never want a bushel of wheat. But the same contract that lets the farmer lock in a price also lets a trader take a view on where a price is heading. That is the door into futures trading, and the rest of this level shows you what is behind it.

Key ideas

• A futures contract is an agreement made today to buy or sell something at a set price on a future date.
• Futures are standardized and traded on an exchange, which makes them easy to buy and sell.
• Most contracts are closed out before they end. Some settle in cash, with no goods delivered.