A futures contract is an agreement to trade a certain item for a certain price on a certain day. For instance, a farmer and a grain buyer might contract on January 1 to trade 100 bushels of wheat for $10/bushel on March 1. In exchange for trading away the possibility of a better price closer to the settlement date, the parties use the contract to gain price and supply certainty for their respective businesses.

While private parties can draw up their own futures contracts, futures are most commonly traded in standardized forms on a recognized exchange. And while parties may satisfy their obligations under the contract by buying/selling the underlying item(s), most futures contracts are cash-settled. That is, parties settle by paying/receiving the cash value between the agreed upon price and the market price on the settlement date.

Often an exchange-traded futures contract is "marked to market," meaning that parties make or receive payments as prices move over the course of the contract. This reduces everyone's risk, making trading less expensive than would otherwise be the case. To keep things simple, the examples here ignore marking and focus instead on overall economic effect.

Let's look at an example based on the contract above: On March 1, the market price for wheat is $20/bushel. If the contract is for physical delivery, then the farmer will deliver 100 bushels for which the grain buyer will pay $1,000. If the contract is cash-settled, then the farmer will pay the grain buyer the difference between the contract price, $10/bushel, and the market price, $20/bushel. At the same time, she will sell her grain to the market at $20/bushel. In both cases, the grain buyer effectively pays $1,000 for his grain--either paying the farmer $1,000 for physical delivery, or buying from the market for $2,000 and receiving a $1,000 payment from the farmer-and the farmer is $1,000 worse off than she would have been had she not executed the contract--either selling to the grain buyer for $1,000 or selling to the market for $2,000 but having to pay $1,000 to the grain buyer to close out the contract. But of course had prices moved the other direction, it would be the farmer who benefited at the expense of the grain buyer.

What if the farmer had noticed the rising prices? One of the advantages to exchange traded futures is that parties can close out or "unwind" their positions early if prices seem to be moving against them. This is done by purchasing/selling the opposing position. So for instance, assume that by mid-February, the price of March wheat had risen to $15 and the farmer believed that it would top $20 by the settlement date. Having sold 100 bushels of March wheat at $10, she now buys 100 bushels at $15, leaving herself down $500. Let's see what happens on settlement day when the price is $20. As before, the farmer owes the grain buyer $1,000, leaving her $1,500 down overall. She makes $500 on the second contract, and is now down $1,000. But, she still owns all her grain, which she now sells to the market for $2,000, leaving her up $1,000, exactly what would have happened under the original contract. Her bet turned out to be exactly even, but if the price had indeed risen past $20, she would have made more money.

The countering/unwinding of positions is made possible on a futures exchange by the central clearinghouse, which serves as the counterparty to all transactions. In the above examples, for instance, the farmers and the grain buyers never actually connect. Rather, each ends up buying from and selling to the central counterparty. This has numerous benefits, the two most important being reduction in counterparty risk and the ability to net opposing positions for margin and marking purposes.

Counterparty risk is the risk taken in trading with any particular party. Without a central counterparty, for instance, a grain buyer in California might have to calculate and track the realtime creditworthiness of a dozen different farmers spread across ten States; a very difficult task. When all trading is through a clearinghouse, the buyer only has to worry about the clearinghouse's credit, and that is almost always extremely good.

Similarly, because all one's positions are held with the counterparty, it can net out opposing positions for credit purposes. This lowers the need for margin calls when losses on some contracts are offset by gains on others, making trading simpler and cheaper.