How futures contracts work: margin, expiry, rolling and contango

Futures are exchange-traded contracts on commodities, stock indices, interest rates and currencies. According to the CFTC, most participants are hedgers managing the risk of price changes; the rest are speculators trading those changes. Smaller “micro” versions of several contracts now exist. The mechanics are different from buying a share or opening a CFD, and several of the risks only show up once a position is open.

This guide explains how a futures contract works, from margin to expiry. It does not forecast any market.

A standardised agreement

The US Commodity Futures Trading Commission (CFTC) describes a futures contract as an agreement to buy or sell a particular commodity at a future date, with the price and quantity fixed when the agreement is made. What makes it a futures contract, rather than a private forward deal, is standardisation.

The exchange sets every term except the price: the contract size, the delivery months, the last trading day, the delivery locations and the acceptable grades of the commodity. A Chicago Board of Trade wheat contract, in the CFTC’s own example, covers 5,000 bushels. Because every contract is identical, large numbers of participants can trade the same instrument, which is where futures liquidity comes from.

In the US, with limited exceptions, commodity futures and options must be traded on an exchange through firms registered with the CFTC. Several of the best-known US futures exchanges sit inside one group: CME Group, which, according to its annual report, acquired the Chicago Board of Trade in 2007 and the New York Mercantile Exchange and COMEX in 2008.

The clearing house in the middle

When you buy a futures contract, you are not really buying from the person on the other side of the trade. The CFTC explains that trades are cleared through a clearing house, which acts as the buyer to every seller and the seller to every buyer.

This has two practical effects. First, you do not need to judge the creditworthiness of the trader you dealt with; CME Group’s annual report describes its clearing house as guaranteeing the contracts traded on its exchanges. Second, you can close a position with anyone. Buy a contract and later sell the same contract, and the two offset and the position is extinguished. The CFTC contrasts this with forward contracts, which cannot be offset in this way: selling an identical forward to someone else leaves you with two contracts, one long and one short.

Margin is a performance bond

Futures traders do not pay the full value of the contract. According to the CFTC, they post margin that is typically between 2% and 10% of the contract’s total value. This is not a down payment on the asset, as it is with stock margin. It is a performance bond: collateral that shows you can meet your obligations.

There are two levels to know:

• Initial margin is the amount the exchange or clearing house requires when you open a position.
• Maintenance margin is a lower (or equal) level that must be kept in the account while the position is open.

If losses take the account below maintenance margin, you receive a margin call and must pay in enough to restore it to the initial level, not just back to maintenance. The CFTC also notes that brokers, known in the US as futures commission merchants, often require customers to hold more margin than the exchange minimum.

Settled every day

The feature that surprises most newcomers is daily settlement. Open positions are “marked to market”: gains and losses are calculated from each session’s settlement price and added to or taken from the account in cash. CME Group’s annual report says its clearing house marks open positions to market at least twice a trading day.

The CFTC’s worked example uses a hypothetical wheat margin of $650 per contract. A farmer who sells ten contracts deposits at least $6,500. On any day the account falls below that level, the farmer must post variation margin to bring it back up.

A futures loss is therefore not a paper loss waiting for you to close; it is cash leaving your account each day. The CFTC warns that many individuals lose all their money speculating in futures and options, and can be required to pay more than they invested initially.

Expiry: delivery or cash

Every contract has a delivery month and a last trading day. From there, it ends in one of two ways:

• Physical delivery: the seller delivers the actual commodity. The CFTC glossary defines first notice day as the first day on which notices of intent to deliver can be received.
• Cash settlement: the short pays the long a cash amount based on the value of the underlying or an index, with no delivery.

In practice, most futures contracts by volume are closed by offsetting before delivery, according to the CFTC. The delivery provision still matters because it keeps the futures price converging with the physical market as expiry approaches. For a speculator who has no use for the physical commodity, the date to watch on a physically settled contract is therefore not only the last trading day but also first notice day.

Rolling and the shape of the curve

Because contracts expire, holding a futures exposure for months means “rolling”: closing the expiring front-month contract and opening one with a later delivery date. What that costs depends on the shape of the futures curve.

• Contango: the CFTC defines this as a market in which prices for later delivery months are progressively higher than the nearest month.
• Backwardation: the opposite, with later months progressively cheaper.

In contango, a long position rolled forward sells the cheaper expiring contract and buys the dearer next one. The CFTC’s advisory on commodity funds warns that when later-dated prices are higher, a fund “may lose money each time front-month contracts are rolled”, and that small month-to-month differences can become a sizeable drag on annual returns. In backwardation, the effect runs the other way and can produce a positive “roll yield”. This is why a commodity futures fund can lag the spot price of the commodity it tracks.

Micro contracts

Standard contracts are large in money terms. CME Group launched Micro E-mini equity index futures on 6 May 2019, with a notional size one-tenth of the traditional E-mini contracts, according to its 2019 annual report.

The CFTC’s weekly Commitments of Traders report lists the E-mini S&P 500 at $50 times the index and the Micro E-mini S&P 500 at $5 times the index. So a one-point move in the index changes the value of an E-mini by $50 and a micro by $5. Smaller size lowers the margin needed, but the leverage per dollar is the same, and daily settlement still applies.

How futures differ from CFDs

Outside the US, many retail traders get commodity and index exposure through contracts for difference instead. The two can track the same market but are built differently:

• Venue and counterparty: futures trade on an exchange and clear through a central clearing house. The UK Financial Conduct Authority describes CFD providers as manufacturing over-the-counter derivatives and selling them directly to investors, so the provider is your counterparty and sets the price.
• Expiry and holding costs: a futures contract expires and must be rolled, with the roll cost set by the curve. CFD positions held overnight instead incur overnight funding charges, which the FCA lists alongside spreads and commissions among the costs it reviewed.
• Leverage rules: futures margin is set by the exchange and clearing house, plus any broker add-on. For UK retail CFD clients, the FCA caps leverage at between 30:1 and 2:1 depending on the underlying asset.
• Transparency: positioning data for US futures markets are published every week by the CFTC in its Commitments of Traders report.

Before you trade

The CFTC suggests working out how much you can afford to lose beyond your initial investment, understanding every obligation of the contract, and reading the risk disclosure your broker is required to provide. For futures, three questions are worth asking before any trade: what the contract size is in money terms, when it expires and how it settles, and how much cash you could need at short notice if the market moves against you.