I wish I knew what futures were, but I’m too embarrassed to ask

A futures contract is an agreement to buy or sell something at a pre-arranged price on a pre-arranged date (known as the delivery date). Futures were developed for agricultural goods such as grain and later for other commodities such as oil, gas and metals. Since the 1970s, financial futures have been widely used for trading in stocks, bonds, currencies and other assets.

Futures may be physically settled (by delivering the asset in exchange for payment) or cash settled (meaning that one party to the contract must make a payment to the other party that reflects the difference between the contract price and the current price of the asset). Physical delivery is common with commodities, while financial futures are almost always cash settled.

Futures contracts are traded on exchanges such as the Chicago Mercantile Exchange (CME) in the US, and play a key role by managing the risk that either buyer or seller fails to meet their obligations. Traders make an up-front payment based on the face value of the contract to the exchange (known as initial margin). They may need to make further payments (maintenance margin) if the trade goes against them. If one party defaults, the exchange steps in to complete the trade, using the margin and drawing on its own reserves if necessary.

Futures can be used for hedging (an airline might buy oil futures to hedge against rising fuel prices), but also for speculative trading. They offer in-built leverage (all the trader pays immediately is the initial margin), or may be more liquid or easier to trade than the underlying asset.

Futures are entirely standardised contracts, with all key terms – such as the specifications of the underlying asset and the delivery date – set by the exchange. If a buyer and seller need customised terms, they would instead use forwards – privately negotiated contracts that don’t trade on an exchange.