Futures Trading: How Futures Contracts Work and How to Trade Them

Futures Contract Specifications

Every futures contract has standardized specifications set by the exchange. The contract size determines the notional value: one E-mini S&P 500 contract controls $50 x the S&P 500 index value (roughly $200,000-250,000). One crude oil contract is 1,000 barrels ($80,000+). One gold contract is 100 troy ounces ($200,000+). The tick size is the minimum price movement: E-minis move in 0.25 index point increments ($12.50 per tick). The contract months specify expiration: futures have quarterly expirations (March, June, September, December) and some have monthly or weekly contracts. The contract unit specifies the asset being delivered and for physical commodities, the delivery location. Each contract's specifications are critical to understand before trading. The notional value determines your leverage, and the tick value determines your profit/loss per price movement. S&P 500 index futures explained →

Margin and Leverage in Futures

Futures margin is not like stock margin. In stocks, margin is a loan from the broker to buy shares. In futures, margin is a performance bond — a good-faith deposit to ensure you can cover potential losses. Initial margin is the amount required to open a position (typically 5-10% of the contract's notional value). Maintenance margin is the minimum amount that must be maintained (usually 75-80% of initial margin). If your account drops below maintenance margin, you receive a margin call and must deposit funds immediately or the position is liquidated. This daily settlement — marking to market — means gains and losses are credited or debited to your account each day. The leverage in futures is substantial. A $12,000 margin deposit on a $200,000 E-mini S&P contract represents 16:1 leverage. A 6.25% adverse move wipes out the entire margin. Proper position sizing and stop-losses are essential. How forex and stock leverage compares →

Futures vs ETFs: Key Differences

Both futures and ETFs provide exposure to broad markets, but they differ in important ways. Futures use leverage (margin), while ETFs are typically bought with cash (though you can use margin for ETFs too). Futures are marked to market daily with cash flows, while ETF gains and losses accrue in the position value. Futures have expiration dates — you must roll contracts before expiration to maintain exposure. ETFs are perpetual — you can hold them indefinitely. Futures settle in cash (for index futures) or physical delivery (for commodities), while ETFs trade like stocks. Futures often have lower transaction costs for large positions but higher costs for small ones. Futures have no management fees (only exchange and broker fees), while ETFs have expense ratios. The choice between futures and ETFs depends on account size, holding period, and whether you want leverage. For long-term retirement accounts, ETFs are more practical. For active trading with leverage, futures are superior. ETFs vs mutual funds vs index funds →

Hedging with Futures

Futures were originally created for hedging. A wheat farmer can sell wheat futures to lock in a price before harvest, protecting against a price decline. An airline can buy crude oil futures to lock in fuel costs, protecting against rising oil prices. A portfolio manager can sell S&P 500 futures to hedge against a market decline without selling the underlying stocks. This use of futures for hedging is essential for businesses to manage risk. The cost of hedging is the basis risk — the difference between the futures price and the expected spot price at expiration. For index futures, the basis includes the interest rate differential and expected dividends. For commodity futures, the basis includes storage costs, insurance, and convenience yield (contango and backwardwardation). Understanding basis risk is critical for effective hedging. Hedging portfolio risk with futures →

What is contango and backwardation?

Contango occurs when futures prices are higher than the expected future spot price. This happens when storage costs, insurance, and financing costs exceed the convenience yield of holding the physical commodity. In contango, rolling futures contracts forward generates a negative return (negative roll yield) because you sell low (nearby contract) and buy high (deferred contract). Backwardation is the opposite: futures prices are lower than the expected future spot price. This occurs when the commodity is in short supply and the convenience yield is high. In backwardation, rolling generates positive roll yield. These conditions matter enormously for commodity futures traders and ETF investors. Many commodity ETFs lose value over time not because the commodity price falls but because of persistent contango that erodes returns through repeated rolling.

How is futures trading taxed?

Futures trading has a unique tax treatment in the US under Section 1256 of the Internal Revenue Code. Futures contracts are marked to market at year-end — even unrealized gains are taxed as if realized. The tax rate is 60% long-term capital gains and 40% short-term capital gains, regardless of holding period. This blended rate is typically lower than the top ordinary income rate. This "60/40" treatment is generally favorable for active traders. Losses are fully deductible against gains and up to $3,000 of ordinary income per year, with unlimited carryforward. Futures are reported on Form 6781 rather than Schedule D. Brokers are required to provide aggregate statements. This tax treatment makes futures more attractive for taxable accounts compared to other short-term trading instruments. Consult a tax professional for individual situations.

What are the main risks of futures trading?

The primary risk is leverage risk. Because futures require only 5-10% margin, a small adverse price move can result in large losses relative to account size. Gap risk occurs when markets open significantly different from the previous close, triggering immediate margin calls. Liquidity risk affects less-traded contracts — spreads widen and fills are poor for illiquid contracts and during after-hours trading. Roll risk arises when rolling contracts forward — the cost of rolling can be significant in contango markets. Operational risk includes technical failures, broker issues, and errors in order placement. Expiration risk means physical delivery contracts require you to close or roll before expiration to avoid taking or making delivery of the underlying commodity. Counterparty risk is minimized by central clearing, but clearinghouse failures are not impossible. Proper risk management means never risking more than 1-2% of account equity on any single trade and using stop-losses on every position.

How do I start trading futures?

Start with education: understand contract specifications, margin requirements, and settlement procedures for the specific futures you want to trade. Open an account with a regulated futures broker (TDAmeritrade, Interactive Brokers, E-Trade, NinjaTrader). Submit additional documentation for futures approval — higher net worth and experience requirements apply. Fund the account with sufficient capital: experts recommend $10,000+ minimum to have enough buffer for margin fluctuations. Start with a demo account (simulated trading) for 3-6 months to develop your strategy. Begin trading with small size: one mini contract (e.g., Micro E-mini S&P, which is 1/10 the size of the standard E-mini). Use stop-losses on every trade. Focus on one or two liquid markets (E-mini S&P, crude oil, gold). Track your performance meticulously. Most retail futures traders lose money in their first year. Patience, discipline, and risk management separate successful traders from those who blow up their accounts.

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