A future contract, more usually written as a futures contract, is a standardized agreement, traded on an exchange that sets its terms, to buy or sell a commodity for delivery in the future at a price determined when the contract is entered into. It obligates each party to fulfill the contract at that specified price, and it may be satisfied by delivery or by offset, which is an equal and opposite trade that cancels the position (CFTC Glossary, CFTC, Economic Purpose of Futures Markets and How They Work).
Some contracts allow cash settlement in place of delivery, and most are liquidated before the delivery date (CFTC, Basics of Futures Trading).
Both sides are bound. That is what separates a future from an option, which gives its buyer the right but not the obligation to buy or sell (CFTC Glossary).
What the Exchange Standardizes and Who Stands in the Middle
The terms come from the exchange, not from the two traders. Exchanges set the amount of the commodity to be delivered, which is the contract size, along with the delivery months, the last trading day, the delivery locations, and the acceptable qualities or grades of the commodity (CFTC, Economic Purpose of Futures Markets and How They Work). Price is the one term the exchange leaves to the market.
Then the clearing house steps between the parties. Futures trades made on an exchange are cleared through a clearing house that acts as the buyer to all sellers and the seller to all buyers, so a contract is technically bought from or sold to the clearing house rather than the party on the other side of the trade (CFTC, Economic Purpose of Futures Markets and How They Work). A clearing organization registered with the CFTC is known as a derivatives clearing organization (CFTC Glossary).
That single counterparty is why offset works. Because the contract is ultimately bought from and sold to the same party, buying and then selling it extinguishes the position, and most futures contracts by volume are liquidated by offsetting and never result in delivery (CFTC, Economic Purpose of Futures Markets and How They Work).
While the position is open, gains and losses move as cash through the margin account each day. That daily settlement mechanic belongs to mark to market.
Future Contract Versus Forward Contract
A forward contract is a cash transaction, common in many industries including commodity merchandising, in which a commercial buyer and seller agree on delivery of a specified quality and quantity of goods at a specified future date. Its terms may be more personalized than those of a standardized futures contract, with delivery time and amount determined between seller and buyer, and the price may be agreed in advance or set at the time of delivery (CFTC Glossary).
The sharper difference is what happens when a party wants out. A forward cannot be offset: a purchaser who buys a forward and then sells an identical forward to a different person now has obligations under two contracts, one long and one short (CFTC, Economic Purpose of Futures Markets and How They Work). A future closes with one opposite trade.
Standardized terms, a central counterparty and offset make a future. Negotiated terms and a bilateral obligation make a forward.
Where a Future Contract Reaches a Firm’s Work
It arrives as paper, on a broker statement. A broker reports a client’s regulated futures contracts on Form 1099-B, and those contracts get their own block: boxes 8 through 11 cover regulated futures contracts, foreign currency contracts and section 1256 option contracts, they are for brokers only, and a broker completing them does not complete any other numbered box except box 1a and, if applicable, box 4 (IRS, Instructions for Form 1099-B).
The block reads nothing like the rest of the form. Box 8 carries the profit or loss realized on closed contracts during the year, box 9 the unrealized profit or loss on contracts open at the end of the prior year, box 10 the unrealized profit or loss on contracts open at the end of the current year, and box 11 the aggregate profit or loss for the year, figured from the other three (IRS, Instructions for Form 1099-B). The proceeds and basis boxes a stock sale would fill stay empty.
Two reporting habits catch preparers out. Regulated futures are reported on an aggregate basis rather than one form per transaction, and box 1a takes a description such as RFC (IRS, Instructions for Form 1099-B). A sale here also includes any closing transaction, defined as a lapse, an expiration, a settlement, an abandonment or other termination of a position (IRS, Instructions for Form 1099-B).
A regulated futures contract is a section 1256 contract (26 U.S.C. 1256(b)(1)), so one held at the close of the taxable year is treated as sold for its fair market value on the last business day and the gain or loss is short-term capital to the extent of 40 percent and long-term capital to the extent of 60 percent whatever the holding period (26 U.S.C. 1256(a)), and mark to market carries that machinery.
That year-end rule does not reach a hedging transaction the taxpayer clearly identified as one before the close of the day it was entered into (26 U.S.C. 1256(e)).
On the books the contract is a derivative, and that definition was written in FASB Statement No. 133. The Accounting Standards Codification superseded all then-existing non-SEC accounting and reporting standards for financial statements issued for interim and annual periods ending after September 15, 2009, and it is the source of authoritative GAAP recognized by FASB for nongovernmental entities today (FASB Statement No. 168).
A derivative instrument is a financial instrument or other contract with three characteristics. The first is one or more underlyings and one or more notional amounts or payment provisions or both. The second is no initial net investment, or an initial net investment smaller than other contracts expected to have a similar response to changes in market factors would require. The third is net settlement, and any one of three things satisfies it: the terms require or permit net settlement, the contract can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement (FASB Statement No. 133, paragraph 6).
An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable, and a notional amount is a number of currency units, shares, bushels, pounds or other units specified in the contract (FASB Statement No. 133, paragraph 7).
A future sits inside the derivative definition on the investment test. Entering into a commodity futures contract generally requires no net investment, while purchasing the same commodity requires an initial net investment equal to its market price, and both contracts reflect changes in the price of the commodity in the same way (FASB Statement No. 133, paragraph 57(b)).
What follows from that classification is the measurement. An entity recognizes all of its derivative instruments in its statement of financial position as either assets or liabilities depending on the rights or obligations under the contracts, and all derivative instruments are measured at fair value (FASB Statement No. 133, paragraph 17).
The instrument turns up in two other places a firm already reads. The Internal Revenue Code lists forward or futures contracts among the financial instruments that can make a partnership distribution a marketable security (26 U.S.C. 731(c)(2)(C)). In commodity markets the physical goods themselves are the actuals, as distinguished from the futures contract (CFTC Glossary).
Common Questions
The standard name is a futures contract, and both phrasings point at the same instrument: an agreement to buy or sell a particular commodity at a future date, with the price and the amount of the commodity fixed at the time of the agreement (CFTC, Basics of Futures Trading).
To shed a price risk they already carry, or to take one on deliberately. Most participants in the futures markets are commercial or institutional commodities producers or consumers, and most are hedgers who trade futures to maximize the value of their assets and to reduce the risk of financial losses from price changes, while other participants are speculators who attempt to profit from price changes in futures contracts (CFTC, Basics of Futures Trading).
A wheat farmer is the standing example. Planting runs the risk of losing money if the price of wheat falls before harvest and sale, and selling wheat futures minimizes that risk by guaranteeing the farmer a predetermined price (CFTC, Economic Purpose of Futures Markets and How They Work).
More than was put in. Because a future is an obligation rather than a right, the loss is not capped at what the account holds. The regulator’s own language is blunt: speculating in commodity futures and options is a volatile, complex and risky venture that is rarely suitable for individual investors or retail customers, and many individuals lose all of their money and can be required to pay more than they invested initially (CFTC, Basics of Futures Trading).
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