A futures contract is an agreement to buy (or sell) some commodity at a fixed price on a fixed date. In other words, it is a contract between two parties; the holder of the future has not only the right but also the obligation to buy (or sell) the specified commodity. This differs sharply from stock options, which carry the right but not the obligation to buy or sell a stock.

   These days, all details of a futures contract are standardized, except for the price of course. These details are the commodity, the quantity, the quality, the delivery date, and whether the contract can be settled in goods or in cash. Futures contracts are traded on futures exchanges, of which the U.S. has eight.

Futures are commonly available in the following flavors (defined by the underlying "cash" product):

        •Agricultural commodity futures
  A commodity future, for example an orange-juice future contract, gives you the right to take delivery of some huge      amount of orange juice at a fixed price on some date. Alternately, if you wrote (i.e., sold) the contract, you have the obligation to deliver that OJ to someone.
Foreign currency futures
For example, on the Euro.
            •Stock index futures
Since you can't really buy an index, these are settled in cash.
            •Interest rate futures (including deposit futures, bill futures and government bond futures)
Again, since you cannot easily buy an interest rate, these are usually settled in cash as well.

Futures are explicitly designed to allow the transfer of risk from those who want less risk to those who are willing to take on some risk in exchange for compensation. A futures instrument accomplishes the transfer of risk by offering several features:
             •Liquidity
             •Leverage (a small amount of money controls a much larger amount)
             •A high degree of correlation between changes in the futures price and changes in price of the underlying commodity.
           In the case of the commodity future, if I sell you a commodity future then I am promising to deliver a fixed amount of the commodity to you at a given price (fixed now) at a given date in the future.
           Here are a couple of contrived examples to illustrate how futures might be traded. If the price of the future becomes very high relative to the price of the commodity today, I can borrow money to buy the commodity now and sell a futures contract (on margin). If the difference in price between the two is great enough then I will be able to repay the interest and principal on the loan and still have some riskless profit; i.e., a pure arbitrage (although I might have to pay some storage fees on the commodity).

Conversely, if the price of the future falls too far below that of the commodity, then I can short-sell the commodity and purchase the future. I can (presumably) borrow the commodity until the futures delivery date and then cover my short when I take delivery of some of the commodity at the futures delivery date. I say presumably borrow the commodity since this is the way bond futures are designed to work; I am not certain that comodities can be borrowed.

Note that there are also options on futures!

Derivatives - Futures and Fair Value

In the case of futures on equity indexes such as the S&P 500 contract, it is possible to make a careful computation of how much a futures contract should cost (in theory) based on the current market prices of the stocks in the index, current interest rates, how long until the contract expires, etc. This computation yields a theoretical result that is called the fair value of the contract. If the contract trades at prices that are far from the fair value, you can be fairly certain that traders will buy or sell contracts appropriately to exploit the differentce (also called arbitrage). Much of this trading is initiated by program traders; it gets restricted (curbed) when the markets have risen or fallen far during the course of a day.

Here are some resources about fair value of equity index futures.

These articles from the Chicago Mercantile Exchange discuss calculating fair value and month-end fair value procedures.
http://www.cme.com/trading/prd/equity/fairvalue2543.html,              http://www.cme.com/trading/prd/equity/fairvaluefaq2544.html
A few words from one of the program traders.
http://www.programtrading.com/fvalue.htm

Subject: Derivatives - Single Stock Futures

Single stock futures are a relatively new product, and are not yet widely known. They are similar in nature to the more familiar futures contracts on indices like the S&P500 or the Dow. Single stock futures trade on the OneChicago Exchange (see link at the bottom of this article).

Like stock options, single stock futures are sold in units called "contracts," each of which controls 100 shares. They also have a strike price and an expiration date. At any one time, approximately four expiration dates are available. These generally follow the quarterly cycle of March, June, September, and December. The expiries for the longest-term contracts range from six to eight months, depending on the time of the year.

Unlike an option, though, a futures contract creates both the right and the obligation to buy or sell the stock at the strike price on the expiration date. The effect of this is that single stock futures
contracts track the performance of the underlying stocks almost exactly, with a couple of caveats. Specifically, for a long position, the price of a single stock futures contract is generally equal to the current stock price, discounted for any dividends that are scheduled to occur prior to the expiration date, plus interest according to prevailing rates. Similarly, for a short position, the price is the current stock price, plus any dividends to be paid, less interest.

Like options, stock futures can be traded freely prior to their expiration dates, and pricing of the contracts varies according to supply and demand. Plus, unexpected changes in dividend payments can cause the performance of a futures contract to vary from the underlying to a certain extent. Thus, these contracts will always be a near-perfect, but not 100% perfect analog to the shares themselves.

One last item to note is that stock futures contracts are cash settled. That means no actual shares change hands upon expiration. Rather, if the stock price is higher than the strike price upon expiration, the seller pays the buyer the difference, and vice versa.

So, how can you put single stock futures to use? Firstly, single stock futures generally require only 20% of the value of the underlying to be put up as margin. Thus they are an easy way to create leveraged positions.

More importantly, if you like to sell stocks short, you may want to consider selling a futures contract, instead. Why is this? Because selling short has a number of disadvantages. For most stocks you must wait for an uptick in the price before you can enter the position (although some stocks have recently been exempted from this requirement). Then you must borrow the stock. If there's no stock available to borrow, you're out of luck. Further, if the stock moves against you and you don't have enough cash in your account to cover the loss, you will have to pay margin interest on the excess for as long as you hold the position.

Selling a single stock future contract eliminates these problems. There is no need to wait for an uptick or borrow the stock. And instead of potentially having to pay margin interest, you collect interest on the position. Lastly, only 20% of the price is tied up in margin. You can invest some or all of the remainder in a safe income instrument and collect even more interest. However, unlike a short position that can be kept open more or less indefinitely, a contract eventually expires.

Futures can also be helpful for tax management. Say you hold an appreciated position in a stock which you would like to sell, but you don't want to pay short-term capital gains taxes. You can instead sell a single stock future contract for the stock and lock in your return. You can then wait until the long-term capital gain cutoff, collecting market interest on the size of the position in the meantime. Once the minimum holding period has passed, you liquidate both positions, and collect your short-term profits while paying long-term capital gains tax. Since the future contract is a near-perfect analog to the underlying stock, you are protected from any losses while you wait. Of course there is a caveat: if the stock drops precipitously while you are holding, you might end up having to pay short term taxes on your profit from your short future position. No strategy is perfect, but it beats losing your gains.

Another common technique is to use futures to create "matched pair" positions. The matched pair strategy is a way of betting on the relative performance of two companies in the same industry. For example, say you think AMD will outperform INTL. You can buy AMD contracts and sell an equal dollar amount of INTL contracts. If AMD does better than INTL, you profit. If not, you will lose money. The interesting thing to note here is that you are protected from a number of risks many investors face. For example, if there is a meltdown in the computer chip industry at large, it is likely that both AMD and INTL will suffer. You will likely remain unaffected, as their relative performance will remain unchanged. The same applies to a broad stock-market crash. Also, note that the interest component of the contracts cancel out, so you are protected from shifts in interest rates.

Stock futures have many other uses for creative investors. The OneChicago exchange's web site offers more detail:
http://onechicago.com/030000_products/oc_030100.html

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