How Much Is a Futures Contract & What Do You Pay?
Understand how futures contracts are valued and the practical financial outlays involved for traders.
A futures contract is a standardized agreement to buy or sell a specific asset at a predetermined price on a future date. This agreement obligates both parties to complete the transaction, regardless of the asset’s market price at expiration. Understanding a futures contract involves its value elements and the financial commitments of trading it.
Factors Determining Futures Contract Price
The theoretical price of a futures contract begins with the current market price of its underlying asset, known as the spot price. The spot price is the immediate cash price for an asset. Changes in this spot price directly influence the corresponding futures price.
The “cost of carry” explains how a futures price deviates from the spot price. This cost represents expenses incurred from holding the underlying asset until the future delivery date. For example, financing an asset purchase means interest expense contributes to the cost of carry.
Storage costs are a component of the cost of carry, especially for physical commodities like oil or grain. These expenses include warehousing, insurance, and potential spoilage. These costs are factored into the futures price to compensate the seller.
Conversely, financial assets like stocks or indices may offer benefits such as dividends that reduce the futures price. These benefits offset some carrying costs. Time to maturity allows more time for these costs or benefits to accumulate.
Market Forces and Price Movement
While the cost of carry model provides a theoretical price, actual futures prices are shaped by dynamic market forces. Supply and demand in the futures market influence price settlement. Fundamental factors unique to each market, such as weather for agricultural commodities or inflation for gold, impact supply and demand.
Market expectations about future supply, demand, and broader economic conditions can cause futures prices to diverge from the cost-of-carry model. This leads to two common market conditions: contango and backwardation.
Contango occurs when the futures price is higher than the spot price, often reflecting normal carrying costs or an expectation of higher future prices. Backwardation describes a market where the futures price is lower than the spot price. This can happen due to immediate supply shortages, strong current demand, or an expectation of lower future prices. As a futures contract approaches expiration, its price tends to converge with the spot price, eliminating significant differences.
Futures contracts undergo “daily settlement” or “mark-to-market.” Profits and losses are calculated and settled daily based on the difference between the previous day’s settlement price and the current day’s price. This adjustment ensures accounts reflect current market values and helps manage risk by requiring prompt loss coverage.
Financial Commitments in Futures Trading
Beyond the theoretical price, financial commitments involve specific contract details. Each futures contract has a defined unit of trading, specifying the quantity of the underlying asset, such as 1,000 barrels of crude oil or 5,000 ounces of gold. This unit determines the total contract value.
Tick size and tick value are crucial. Tick size is the minimum price fluctuation a contract can experience, while tick value is the monetary gain or loss associated with that minimum movement. For instance, an E-mini S&P 500 futures contract has a tick size of 0.25 index points, translating to a tick value of $12.50 per contract, meaning a 1-point move is worth $50.
Traders do not pay the full contract value upfront; instead, they deposit “initial margin.” This deposit opens a position, typically ranging from 3% to 12% of the contract’s notional value. For example, a $100,000 crude oil futures contract might only require an initial margin of $5,000.
Once a position is open, “maintenance margin” is the minimum balance required in the account. If account equity falls below this level due to unfavorable price movements, a “margin call” is issued. This requires depositing additional funds to restore the initial margin level. The use of margin involves leverage, which magnifies both potential gains and losses.