In a record-setting day this week, the price of a barrel of crude dropped to -$37.63. That’s right, a barrel of West Texas Intermediate crude to be delivered in May ended Monday below zero. The news prompted questions about how futures contracts work and how this negative price will affect us individually and economically.
Futures contracts allow buyers and sellers to lock in a price of an underlying asset, such as oil, for a future date. Each futures contract is standardized with a set quantity, expiration date, and pre-determined price. The most important benefit of futures contracts is that they eliminate the price uncertainty of the underlying asset for both buyers and sellers.
How a Futures Contract Works
Futures markets are highly speculative because a trader doesn’t have to pay the full value of a contract when entering it. Instead, the broker only requires a trader to deposit an amount of cash, called initial margin amount, that is equivalent to a small percentage of the full contract value.
For example, let’s say you buy one oil futures expiring in June with the price per barrel at $22. A futures oil contract on the Chicago Mercantile Exchange is 1,000 barrels of oil, so the total value of your one contract is $22,000 ($22 x 1,000). Assuming the broker requires 10 percent as the initial margin, when you enter into the contract, you only have to pay $2,200.
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