What is a futures contract?

A futures contract is an agreement to buy or sell a commodity, currency, or another instrument at a predetermined price at a specified time in the future.

Unlike a traditional spot market, in a futures market, the trades are not ‘settled’ instantly. Instead, two counterparties will trade a contract, that defines the settlement at a future date. Also, a futures market doesn’t allow users to directly purchase or sell the commodity or digital asset. Instead, they are trading a contract representation of those, and the actual trading of assets (or cash) will happen in the future – when the contract is exercised.

As a simple example, consider the case of a futures contract of a physical commodity, like wheat, or gold. In some traditional futures markets, these contracts are marked for delivery, meaning that there is a physical delivery of the commodity. As a consequence, gold or wheat has to be stored and transported, which creates additional costs (known as carrying costs). However, many futures markets now have a cash settlement, meaning that only the equivalent cash value is settled (there is no physical exchange of goods).

Additionally, the price for gold or wheat in a futures market may be different depending on how far is the contract settlement date. The longer the time gap, the higher the carrying costs, the larger the potential future price uncertainty, and the larger the potential price gap between the spot and futures market.

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