The Futures Contract

The whole unit on one sheet: how a futures contract is built, closed out, and, on the rare occasion, delivered.

Which One-Liners Win Points?

• Futures are standardized by the exchange; forwards are customized by the two parties. Only price is negotiated in a futures contract; forwards negotiate every term.
• Futures trade on a regulated exchange; forwards are private, over-the-counter (OTC) agreements negotiated away from any exchange.
• The clearinghouse guarantees futures performance; a forward carries counterparty risk with no central guarantor.
• Futures are marked to market daily through the margin system; a forward's full gain or loss is realized at delivery.
• Futures are liquid and easily offset; forwards are usually held to delivery because there is no standardized secondary market to trade out of.

How Does a Trader Get Out of a Position?

• Offsetting (also called liquidating or closing out) closes a position with an equal and opposite trade in the same contract and same delivery month. A long offsets by selling; a short offsets by buying.
• Only the price difference between the opening and closing trades is realized as profit or loss. No commodity changes hands.
• The closing trade must match the delivery month exactly. A different month does not offset the position; it creates a spread, two open positions, and leaves the original obligation live.
• The vast majority of futures positions are offset before delivery; only a small fraction actually go to delivery.

Who Guarantees the Trade?

• The clearinghouse becomes the buyer to every seller and the seller to every buyer, a substitution called novation.
• It protects itself with margin (performance bonds) from both sides and by marking positions to market daily, collecting from the losing side and paying the winning side each day.
• Clearing members carry accounts directly with the clearinghouse and must meet its capital and margin standards.
• Non-clearing members cannot deal with the clearinghouse directly; they must clear trades through a clearing member, which guarantees those trades to the clearinghouse.

What Happens on Delivery?

• The basis grade (also called par grade or contract grade) is the standard quality deliverable at the contract price with no adjustment. The quoted futures price refers to this grade.
• A better grade delivered earns a premium above the contract price; a lower grade settles at a discount below it.
• The short (the party making delivery) generally chooses which permitted grade to deliver.
• This delivery "basis grade" is unrelated to the hedging "basis" (cash price minus futures price) covered in later units; the two share only a root word.

Which Gotchas Trip Students Up?

• Pairing "no counterparty risk" with a forward, or "customized" or "OTC" with a futures contract, is always wrong.
• Buying back a different delivery month does not offset a position; it creates a spread and leaves the original obligation open.
• The exchange or a broker does not guarantee performance; the clearinghouse does, through novation.
• A higher grade earns a premium, and a lower grade settles at a discount. Reversing them is the classic delivery trap.
• A non-clearing member never settles directly with the clearinghouse; its clearing member stands between them and guarantees its trades.

What Is the Memory Aid for Futures Versus Forwards?

A future is factory-made: identical to every other, so a trader exits any time by trading one back on the exchange. A forward is a handshake: custom terms with one named counterparty, held until delivery. To exit a futures position, trade the opposite side in the same month; Longs sell, shorts buy; the wrong month builds a spread instead of an exit.

One-Breath Recap

A futures contract is standardized, exchange-traded, cleared, and marked to market daily, so counterparty default risk is minimal, while a forward is a private, customized agreement with no clearinghouse and full counterparty risk; a trader exits a futures position by offsetting, an equal and opposite trade in the same delivery month, since a different month creates a spread rather than a close, and the vast majority of positions are offset rather than delivered; the clearinghouse becomes buyer to every seller and seller to every buyer through novation, protected by margin and daily marking to market, with clearing members dealing directly and non-clearing members routing through them; on the rare delivery, the short delivers the basis grade or a substitute grade at a premium or discount and generally chooses which grade to deliver.

Need more than the recap? Read the full The Futures Contract unit.