Learn the stock market › Short selling, warrants and leverage › Lesson 6 of 7

What are futures?

Short answerA futures contract is an agreement to buy or sell something at a set price on a set day. Both sides are bound, unlike an option. An exchange-traded index future settles every day: whoever lost on the day's move pays and whoever gained receives. You only put up a margin deposit, and the loss can be larger than it.

A deal about the future

The buyer of a future promises to buy at a price agreed today, and the seller promises to sell. If the price rises by the last day, the buyer gains and the seller loses the same. If it falls, the other way round. Unlike an option, neither side can walk away.

An index future is worth the index times a fixed amount per point, and it settles every day: the difference from the previous close is paid between the two sides. Exchanges set the amount per point and the last day in the contract terms.

Daily settlement, for real

The S&P 500's worst ten trading days in a row, from Sep 26, 2008 to Oct 10, 2008, when the index fell 25.9%. How one bought contract would have settled:

Day	S&P 500	Daily settlement	Total
Sep 26, 2008	1213.3	–	–
Sep 29, 2008	1106.4	−$5,342	−$5,342
Sep 30, 2008	1166.4	+$2,997	−$2,346
Oct 1, 2008	1161.1	−$265	−$2,610
Oct 2, 2008	1114.3	−$2,339	−$4,949
Oct 3, 2008	1099.2	−$753	−$5,702
Oct 6, 2008	1056.9	−$2,117	−$7,819
Oct 7, 2008	996.2	−$3,033	−$10,852
Oct 8, 2008	984.9	−$564	−$11,417
Oct 9, 2008	909.9	−$3,751	−$15,168
Oct 10, 2008	899.2	−$535	−$15,703

In this example a contract is worth $50 for each index point. Worked out on the index close; the future's own price differs slightly.

A contract was worth $60,664 when the period began, and the ten days cost the buyer $15,703. A futures buyer only puts up a margin deposit, not the whole value. Had the deposit been 10% of the value, $6,066, the loss was 2.6 times the deposit. The real requirement is set by the clearing house and can be raised when markets swing.

Why futures are used

A fund manager who owns many US stocks can sell index futures to protect against a fall without selling the stocks. Someone who wants a large exposure for little money can buy them. That is leverage, and with daily settlement the loss shows up every evening.

Test yourself

You have bought an index future and the index falls five days in a row. When do you pay?