How a Futures Contract Works: Obligations and Payoffs
A futures contract obligates both buyer and seller with no way out. Learn what that means, how mark-to-market daily settlement works, and how to draw the payoff diagram.
The surprising feature of futures is this: once you sign, you cannot walk away.
Not because you do not want to. Because you cannot. The contract obligates both sides. If the price moves against you by the time the contract expires, you still have to perform. No option. No escape.
That is the feature that separates futures from almost everything most people have seen before in finance. Most of investing is about choice. Futures remove it.
The Definition
A futures contract is a standardized financial derivative that obligates the buyer to purchase and the seller to sell an asset at a predetermined price on a predetermined future date.
The word "obligates" is the one to hold onto. This is not a bet you can walk away from. At the agreed date, the buyer must buy and the seller must sell at the price that was locked in at the start.
A concrete example: an investor enters a contract to buy 100 barrels of oil at $70 per barrel, with the contract expiring three months from today. On that date, one side must buy, and the other must sell, at $70, regardless of where the market price has moved.
If oil trades at $65 at expiry, the buyer still pays $70. That is a $5 loss per barrel.
If oil trades at $75, the buyer pays $70 and keeps the $5 difference. That is profit.
The contract does not adjust based on how either party feels about the outcome.
Why Do People Enter These Contracts?
The purpose is not always speculation. A corn farmer, for example, might enter a futures contract agreeing to sell 1,000 kilograms of corn at $2 per kilogram three months from now. If the market price drops to $1 at expiry, the farmer still receives $2: protection against a bad harvest season.
Futures allow both buyers and sellers to lock in certainty about a future price. One side is protecting against prices falling; the other is protecting against prices rising. The contract transfers the price risk from one party to the other.
Key Characteristics
Standardized agreements. Futures are standardized in every dimension -- the exchange defines all of these:
- Size -- how many units per contract
- Expiration date -- when the contract settles
- Underlying asset -- exactly what is being traded
- Quantity -- the total amount
- Quality specifications -- grade or standard of the asset
There is no customization available.
Clearing house as intermediary. A clearing house sits between every buyer and seller, guaranteeing that both sides fulfill the contract. Neither party deals directly with the other.
Marked to market daily. This is the critical feature that separates futures from other derivatives. Whatever gains or losses accumulate in a futures position are settled every single day throughout the life of the contract, not at expiry.
If the oil price moves from $70 to $68 on Tuesday, the long position settles a $2 loss on Tuesday evening. This prevents losses from accumulating silently over months. Daily settlement is what keeps default risk low in the futures market.
Highly liquid. Standardized contracts on an exchange attract high trading volume. High volume means positions can be entered and exited easily.
Low counterparty risk. With a clearing house guaranteeing performance, the chance of the other side defaulting is very low.
The Payoff Diagram
Every futures contract has two sides. The buyer holds a long position (betting the price rises). The seller holds a short position (betting it falls).
The formulas are simple:
- Long position: payoff = ST minus K
- Short position: payoff = K minus ST
K is the price agreed at the start. ST is the actual market price at the end. Whoever is right pockets the difference. Whoever is wrong pays it.
Say you agreed on K = $100 (today's locked-in price). If the stock is trading at $110 when the contract expires, the long (buyer) gains $10. The short (seller) loses $10. If it drops to $90, the short gains $10 and the long loses $10.
Move your cursor over the chart below. Hover left of K to see the short position profit. Hover right of K to see the long position profit. Drag the slider to change the agreed price.
Interactive Futures Payoff Explorer
Move your cursor over the chart to read off payoffs. Adjust K to shift the contract price.
Long formula
ST - $100
Short formula
$100 - ST
Break-even (both)
ST = $100
Put that on a chart: the long position is a line sloping upward from left to right, crossing zero at K. The short is the mirror: sloping downward, crossing zero at the same point. Both lines are straight. The payoff moves one-for-one with the underlying price.
This straight-line shape is called linearity. It is what distinguishes futures and forwards from options, which have a curved, asymmetric payoff.
One note worth keeping: stock prices cannot go negative. The maximum loss on a long position is capped at K (the underlying can only fall to zero). The upside is unlimited.
The Essentials
- A futures contract obligates both buyer and seller. There is no optionality. At expiry, the buyer must buy and the seller must sell at the agreed price, regardless of where the market moved.
- Futures are marked to market daily. Gains and losses are settled every single day throughout the contract, not just at maturity. This daily settlement keeps default risk low.
- Long payoff is ST minus K; short payoff is K minus ST. Both produce straight-line diagrams. The long profits when the underlying rises above the strike; the short profits when it falls below.
There is another type of derivative with an identical obligation and an identical payoff formula. It is called a forward contract. The diagrams look the same. Almost everything else about it is different.
Further Reading
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