A futures contract (also known as a standardized forward contract) is an agreement to exchange an underlying asset at a predetermined price on a specific date in the future. The purpose of a futures contract is to help parties mitigate price volatility risks by "locking in" the asset's price at the current time for future delivery.

Key components of a futures contract include the underlying asset (such as stocks, stock indices, commodities, currencies, etc.), the expiration date (also known as the delivery date of the asset), the agreed-upon price, the standardized contract size, the delivery method (whether physical delivery or cash settlement), the minimum price fluctuation (also known as the tick size), and the margin levels, including initial margin and maintenance margin.

Futures contracts are traded on centralized exchanges, offering high liquidity and leverage through margin. Unlike forward contracts, futures contracts are not customizable but are standardized and traded on derivatives exchanges.

Futures contracts require both the buyer and the seller to maintain a margin account with the commodity exchange. If the margin account falls below the required level, additional margin may be required according to the exchange's rules. For example, an oil producer plans to produce 1 million barrels of oil in the next year and is ready to deliver in 12 months. Currently, let's assume the price of oil is $75 per barrel. However, given the volatility of oil prices, the market price 12 months later may differ significantly from the current price. If the producer believes that the price of oil will be higher in a year, they may choose not to lock in the price now. But if they think that $75 is a good price, they can lock it in through a futures contract. However, by signing this contract, even if the spot market price is $77 per barrel in a year, the producer is still obligated to deliver 1 million barrels of oil at $75 million, or $75 per barrel.

Let's take an example of a futures contract on an exchange. For instance, the contract size for oil on the Chicago Mercantile Exchange is 1,000 barrels. If someone wants to lock in the price (buy or sell) for 100,000 barrels of oil, they would need to buy or sell 100 contracts. Similarly, to lock in the price for 1 million barrels of oil, they would need to buy or sell 1,000 contracts.

For retail investors and portfolio management funds, they are typically not interested in delivering or receiving the underlying asset but may be interested in profiting from price fluctuations.

For example, it is now January, and oil contracts for April delivery are trading at $75 per barrel. If a trader believes that oil prices will rise before the contract expires in April, they might buy a contract at $75. However, the trader is not required to pay $75,000 upfront (which is $75 multiplied by the contract size of 1,000 barrels). Instead, they would be required to post an initial margin, typically a few thousand dollars per contract, depending on the exchange's rules.

The profit or loss of this position in the account will fluctuate as the price of the futures contract changes. If the losses become too large, the investor may be required to add more funds, known as maintenance margin.

The final profit or loss of the trade will be realized when the position is closed. If the buyer sells the contract at $80, they will make a profit of $5,000 (i.e., $80 minus $75, multiplied by 1,000 barrels). Conversely, if the price drops to $70 and they close the position, they will incur a loss of $5,000.

Source: Multiple sources